Grok's tip #6/10: Be Aligned: Buy This, Not That!

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grok87
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Grok's tip #6/10: Be Aligned: Buy This, Not That!

Post by grok87 » Sat Jan 29, 2011 8:01 pm

Tip #6/10: Be Aligned: Buy This, Not That!

My Tip #6 is to only buy investment products where the financial interests/incentives are fully aligned with your own. Recently I read the Big Short by Michael Lewis, and he made the same point by quoting Charlie Munger. Here’s the full passage:
Michael Lewis in ‘the Big Short’ wrote: Warren Buffett had an acerbic partner, Charlie Munger, who evidently cared a lot less than Buffett did about whether people liked him. Back in 1995, Munger had given a talk at Harvard Business School called “The Psychology of Human Misjudgment.” If you wanted to predict how people would behave, Munger said, you only had to look at their incentives. FedEx couldn’t get its night shift to finish on time; they tried everything to speed it up but nothing worked-until they stopped paying night shift workers by the hour and started to pay them by the shift. Xerox created a new, better machine only to have it sell less well than the inferior older ones-until they figured out the salesmen got a bigger commission for selling the older one. “‘Well, you can say, ‘Everybody knows that,’” said Munger. “I think I’ve been in the top five percent of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little further.”
So here are a few examples…

1) Buy Vanguard Bond Funds, not Fidelity (actively managed) bond funds! Fidelity’s actively managed bond funds' higher expense ratios incent them to take more risk to try to beat their drag on performance. In the recent credit-crisis period the results were not pretty. For example Fidelity Intermediate Bond fund and Fidelity Investment Grade Bond fund lagged the Barclays Aggregate Bond index in 2008 by 11% points and 12% points respectively. Fidelity even stuffed its TIPs fund with subprime bonds- in 2007 it lagged the TIPs index by 2.5%. By contrast Vanguard, with its low expenses and full alignment with its investors, avoided those dodgy subprime and other bonds. Here is a NPR piece which mentions Mabel Yu, a Vanguard bond analyst:

http://www.npr.org/templates/story/stor ... =104962188
For a bond to get a AAA rating, it is supposed to have passed a particularly strong test. The rating agencies would simulate a worst-case scenario and see how the bond held up. But those scenarios were sometimes perplexing to outsiders. Mabel Yu analyzed bonds for Vanguard, which manages $400 billion in bond investments. The new deals would land on her desk, with their AAA ratings. She says she could never get a straight answer about what the worst-case scenario really was.
"I got names of the rating agency analysts, and I asked them lots of questions," she says. "In the beginning, the questions would be 15 minutes to half an hour. But then it turned into hours, and many hours." She asked them about the possibility of house prices falling, of interest rates rising, of people not being able to refinance their mortgages. "If all of those things happen at same time, what would happen to our investment? I could not get a straight answer."
Yu says she was told repeatedly that she worried too much. "I felt so dumb," she says, adding that she was told, "Don't worry about it. Have a life."
2) Buy Credit Union CDs not Bank CDs! Many investors rightly worry that if interest rates rise sharply their bonds might take a big price hit (price hit ~=duration * interest rate move). Longer term CDs often offer an attractive combination of a spread over treasuries plus the ability to withdraw early at a small penalty of a few months interest. If rates rise sharply you can withdraw early and reinvest at the higher rates. But watch the fine print! May banks have clauses in their CD contracts that reserve their right to deny early withdrawal requests. Pentagon Federal Credit Union doesn't have this fine print- at worst you may just have to give them 2 months written notice to withdraw early.

3) Buy Vanguard ETFs, not Ishares ETFs! One of the advantages of broad index fund investing is that you end up owning (through the index fund) hard to find securities that other investors may want to short. Funds can often realize significant income by lending these securities out. But as this article points out, while Vanguard passes on all of the securities lending income to its funds, Ishares somehow thinks they are entitled to half of it!

http://www.news-to-use.com/2010/01/gett ... -etfs.html

4) Buy common equities, not corporate bonds! Here is what David Swensen has to say about corporate bonds:

http://registeredrep.com/mag/finance_un ... _approach/#
David Swensen wrote:Corporate bond investors find the deck stacked against them as corporate management's interests align much more closely with equity investors' aspirations than with bond investors' goals. A further handicap to bond investors lies in the negative skew of the potential distribution of outcomes, limiting the upside potential without dampening the downside possibility...IBM illustrates the problem confronting purchasers of corporate debt. The company issued no long-term debt until the late 1970s, as prior to that time IBM consistently generated excess cash. Anticipating a need for external finance, the company came to market in the fall of 1979 with a $1 billion issue, at the time the largest-ever corporate borrowing. IBM obtained a triple-A rating and extremely aggressive pricing on the issue, which resulted in an inconsequential yield spread over U.S. Treasuries and (from an investor's perspective) underpriced call and sinking fund options. Bond investors spoke of the “scarcity value” of IBM paper, allowing the company to borrow below U.S. Treasury rates on an option-adjusted basis. From a credit perspective, IBM debt had nowhere to go but down. Fourteen years later, IBM's senior paper carried a rating of single A, failing to justify both the rating agencies' initial assessment of IBM's credit and the investors' early enthusiasm for IBM's bonds. Bond investors had no opportunity to lend to the fast-growing, cash-generative IBM of the 1960s and 1970s. Instead, bond investors faced the option of providing funds to the 1980s and 1990s IBM that needed enormous sums of cash. As IBM's business matured and external financing requirements increased, the quality of the company's credit standing eroded.
5) Buy common equities not preferred equities! Common shareholders are typically well compensated if the company goes private. In contrast, preferred shareholders may not be and risk being simply ignored by new management-i.e. they may find out the hard way that their interests are not properly aligned. This is called being “Waldenized”- you can read about it here:

http://boards.fool.com/quotwaldenizedqu ... e#28160296


6) Buy companies that are "buying" back their shares, not "selling" in an IPO! If management is selling, why are you buying? Studies have shown that IPOs underperform in the long term. For example see:

http://www2.hawaii.edu/~fima/Working_Papers/iposeo.pdf

Part of the trouble is that company management knows more than you do (asymetry of information). They are unlikely to sell the company when the market for stocks in their industry is low. Rather they will wait and try to sell at the top. A recent egregious example of this is the 2007 IPO of Blackstone- a private equity shop. Blackstone's CEO Steve Schwarzman took the company public in mid 2007, just before the credit bubble (which fueled private equity transactions) burst. So IPO investors were basically betting against Schwarzman's knowledge of the private equity market and how overextended it was- a dangerous thing to do. This chart shows that since its IPO Blackstone underperformed the S&P 500 by about 40%, or about 10% per annualized.

http://finance.yahoo.com/echarts?s=BX+I ... =undefined

So remember, only buy investment products where the financial interests/incentives are fully aligned with your own.

Here are the previous 5 installments in this 10 part series:

Tip #1: Take your risk on the equity side.
http://www.bogleheads.org/forum/viewtop ... 1296349581

Tip #2: Use Cash to dampen portfolio risk
http://www.bogleheads.org/forum/viewtop ... 1296349639

Tip #3: Index, Index, Index! But...
http://www.bogleheads.org/forum/viewtop ... 1296349812

Tip #4: Rebalance Early and Often.
http://www.bogleheads.org/forum/viewtop ... highlight=

Tip #5: To keep real wealth, skip Gold, Buy TIPs
http://www.bogleheads.org/forum/viewtop ... highlight=

cheers,
Last edited by grok87 on Tue Feb 01, 2011 11:27 pm, edited 6 times in total.
Keep calm and Boglehead on. KCBO.

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tetractys
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Post by tetractys » Sat Jan 29, 2011 8:42 pm

Grok,

Very interesting! Now I'm wondering if at least one of the investments I hold is not entirely aligned with my interests.

Good stuff, Tet
RESISTANCE IS FRUITFUL

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Post by fmoore » Sat Jan 29, 2011 10:23 pm

Thanks for the great info.

By the way, the link to your tip #5 points to tip #4.

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Post by Sriracha » Sat Jan 29, 2011 11:10 pm

Thanks for all the time and effort you are putting into your informative series and for generating so much useful board discussion.
Don't reach for yield.

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grabiner
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Post by grabiner » Sat Jan 29, 2011 11:28 pm

Alignment issues are important for mutual funds and investment advisors, but I don't think they are important for most individual investments; alignment risk is a known risk which is priced into the cost by an efficient market. For example, corporate bondholders' interests are not aligned with the corporation's interest, which increases the risk and thus increases the yields which investors demand in order to lend money to corporations.

In contrast, alignment issues are important when the price does not come through the market. If the expenses of running a mutual fund drop from 0.3% to 0.2% as the fund gets larger, the mutual fund owner has an interest in keeping the same expense ratio and pocketing the extra 0.1%, and this often happens. (For example, closed funds still charge 12b(1) fees for marketing.) If you are the owner (as with Vanguard), there is no such interest and the reduction goes into your pocket.

Similarly, if your advisor collects a 1% commission if you buy a load fund and no commission if you buy a no-load fund, his interests are not aligned with yours; if he collects a 0.5% fee of assets under management, his interests are directly aligned with yours, as he will collect more money if your investments earn more money.
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Langkawi
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Re: Grok's tip #6/10: Be Aligned: Buy This, Not That!

Post by Langkawi » Sat Jan 29, 2011 11:36 pm

grok87 wrote:2) Buy Credit Union CDs not Bank CDs!
This claim needs a lot more data to support it. I realize that blind faith regarding the wholesomeness of credit unions is part of the Boglehead zeitgeist, but you should do better.

Winthorpe
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Post by Winthorpe » Sun Jan 30, 2011 2:15 am

Very well done! I'm loving the Grok tip series.

grok87
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Post by grok87 » Sun Jan 30, 2011 9:41 am

grabiner wrote: For example, corporate bondholders' interests are not aligned with the corporation's interest, which increases the risk and thus increases the yields which investors demand in order to lend money to corporations.
I think Swensen would say that historically there has not been enough increased yield to compensate investors for the higher risks. Partly this is because there are a number of institutional investors who cannot buy equities but can buy corporate bonds. These investors bid up the price of corporate bonds and bid down the yield spread over treasuries. So corporate bonds end up being not risk efficient compared to a combination of treasuries and equities.

I think it is a flawed argument to say that the market always compensates all investors for all investment risks (not sure if you were saying that but let me take your argument, as I perceive it, to the extreme). Take foreign currency t-bills or just foreign currency. From a US investors perspective there is little return but enormous (currency) risk. I would argue that foreign currency tbills have no place in a US investors portfolio.

cheers,
Keep calm and Boglehead on. KCBO.

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Post by grok87 » Sun Jan 30, 2011 9:47 am

tetractys wrote:Grok,

Very interesting! Now I'm wondering if at least one of the investments I hold is not entirely aligned with my interests.

Good stuff, Tet
Thanks Tet- and also thanks to fmoore, srifracha and winthhorpe- glad you are enjoying them...
Keep calm and Boglehead on. KCBO.

grok87
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Re: Grok's tip #6/10: Be Aligned: Buy This, Not That!

Post by grok87 » Sun Jan 30, 2011 9:48 am

Langkawi wrote:
grok87 wrote:2) Buy Credit Union CDs not Bank CDs!
This claim needs a lot more data to support it. I realize that blind faith regarding the wholesomeness of credit unions is part of the Boglehead zeitgeist, but you should do better.
Well that was the headline- not the paragraph. I did mention PenFed specifically and discussed their policy on early withdrawals. Lots more discussion in this thread
http://www.bogleheads.org/forum/viewtop ... highlight=
cheers,
Keep calm and Boglehead on. KCBO.

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Post by exoilman » Sun Jan 30, 2011 9:55 am

Thanks for your effort and fine work. I hope the new kids on the block pay attention to your work.

Sam

staythecourse
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Post by staythecourse » Sun Jan 30, 2011 10:34 am

Thanks Grok.

Your point all investors should know, but surprisingly the industry mesmorizes us to forget.

If anything this tip is another strong favor towards investing in index funds. Then you know what your investment is supposed to do. Any active management automatically invites manager risk. No thanks.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

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Post by hsv_climber » Sun Jan 30, 2011 10:50 am

grok87 wrote: I think Swensen would say that historically there has not been enough increased yield to compensate investors for the higher risks. Partly this is because there are a number of institutional investors who cannot buy equities but can buy corporate bonds. These investors bid up the price of corporate bonds and bid down the yield spread over treasuries. So corporate bonds end up being not risk efficient compared to a combination of treasuries and equities.
grok, you have to do better than just show somebody's words out of a context...

In his book, Swensen actually provide the numbers:
Annual 10 year return (prior to the date of publishing his book "Unconventional Success"):
- US Treasury: 6.7%
- Corporate: 7.4%

So, if someone would've invested $10,000 for 10 years (in the 10 year period prior the publishing date of the Swensen's book) then he'd have:

- US Treasury: $19,505
- US Corporate: $20,911

I'd say extra $1,400 (14% of the principal over 10 years) is a good enough compensation for the extra risk for me.

grok87
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Post by grok87 » Sun Jan 30, 2011 1:34 pm

hsv_climber wrote:
grok87 wrote: I think Swensen would say that historically there has not been enough increased yield to compensate investors for the higher risks. Partly this is because there are a number of institutional investors who cannot buy equities but can buy corporate bonds. These investors bid up the price of corporate bonds and bid down the yield spread over treasuries. So corporate bonds end up being not risk efficient compared to a combination of treasuries and equities.
grok, you have to do better than just show somebody's words out of a context...

In his book, Swensen actually provide the numbers:
Annual 10 year return (prior to the date of publishing his book "Unconventional Success"):
- US Treasury: 6.7%
- Corporate: 7.4%

So, if someone would've invested $10,000 for 10 years (in the 10 year period prior the publishing date of the Swensen's book) then he'd have:

- US Treasury: $19,505
- US Corporate: $20,911

I'd say extra $1,400 (14% of the principal over 10 years) is a good enough compensation for the extra risk for me.
Hsv_climber,
Well remember that that 0.7% average annual return difference is before fees. You need to pay a mutual fund fee with corporates to diversify whereas with treasuries you can just skip the fund and buy them directly. Adjusting for that the extra return for that 10 year period (dates?) is more like 0.4% points.
Here's the full 38 year results from 1973-2010:

For the 38 years through 1/11/11 here are the returns: corporate index...8.28%
treasury..........7.96%

For that period the meagre 32 bps of outperformance would entirely have been lot to fees giving investors no compensation for all the extra risks of treasuries (2008 year, etc)
Cheers,
Keep calm and Boglehead on. KCBO.

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Post by hsv_climber » Sun Jan 30, 2011 3:25 pm

grok87 wrote: Hsv_climber,
Well remember that that 0.7% average annual return difference is before fees. You need to pay a mutual fund fee with corporates to diversify whereas with treasuries you can just skip the fund and buy them directly.
But Mr. Grok wrote in the OP: "1) Buy Vanguard Bond Funds,"

So, lets compare apples to apples, since there is no difference in fees for VG bond funds between Investment-Grade & Treasury.
grok87 wrote: For the 38 years through 1/11/11 here are the returns: corporate index...8.28%
treasury..........7.96%

For that period the meagre 32 bps of outperformance would entirely have been lot to fees giving investors no compensation for all the extra risks of treasuries (2008 year, etc)
What index are you looking at? Obviously, we can look at different indices and derive different conclusions. Long Term Corporate & high-yield have never delivered the desired results.
OTOH, right now VG Short Term Inv. Grade fund (which is recommended by a few Boglehead authors) has a SEC yield of ~2% vs VG Short Term Treasury yield of 0.49%.
I'd say 1.5% extra yield is more than enough compensation for the risk of owning short term corporate bonds (for the record - VG ST Inv. Grade is ~12% of my portfolio).

Also, Swensen, with all of his bashing of Munis & Corporates, still recommends ultra-short Munis fund, also known to be VG Tax-Exempt Money Market Fund.

Cheers and please stop generalizing and switch to accurate numbers in your Tips.

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Post by beardsworth » Sun Jan 30, 2011 3:56 pm

Aside from questions of whether the added risk of corporate bonds is adequately "compensated," the extra performance of corporates over Treasurys may be smaller than it seems on first impression, after considering that the interest earnings of the corporate bonds were subject to state income tax but the interest earnings of the Treasurys were not. (This would not, of course, be an issue in the handful of states which have no income tax.)

Marc

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Langkawi
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Post by Langkawi » Sun Jan 30, 2011 4:27 pm

MarcMyWord wrote:(This would not, of course, be an issue in the handful of states which have no income tax.)
Or in tax-advantaged accounts.

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Re: Grok's tip #6/10: Be Aligned: Buy This, Not That!

Post by Langkawi » Sun Jan 30, 2011 4:31 pm

grok87 wrote:
Langkawi wrote:
grok87 wrote:2) Buy Credit Union CDs not Bank CDs!
This claim needs a lot more data to support it. I realize that blind faith regarding the wholesomeness of credit unions is part of the Boglehead zeitgeist, but you should do better.
Well that was the headline- not the paragraph. I did mention PenFed specifically and discussed their policy on early withdrawals. Lots more discussion in this thread
http://www.bogleheads.org/forum/viewtop ... highlight=
cheers,
Well then your headline should have been "Buy PenFed CDs, not Bank or Credit Unions other than PenFed CDs".
Blind trust of (generic) credit unions is just as risky as blind trust of (generic) banks.

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Post by conundrum » Sun Jan 30, 2011 5:30 pm

Thanks grok for your 6th installment. I appreciate all your work in sharing your tips with us.

Drum :sharebeer

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Post by Doc » Sun Jan 30, 2011 6:07 pm

grok87 wrote: Hsv_climber,
Well remember that that 0.7% average annual return difference is before fees. You need to pay a mutual fund fee with corporates to diversify whereas with treasuries you can just skip the fund and buy them directly. ,
Come on Stranger, play fair.

iShares Intermediate Credit Bond Fund CIU expense ratio 0.20. :wink:

That's another whole half a percent.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Post by Beagler » Sun Jan 30, 2011 6:25 pm

Wellngton Fund's bond manager does not share your disdain for corporate bonds. Swensen's sentiments aside, why do think Wellington doesn't ascribe to your investing view?
“The only place where success come before work is in the dictionary.” Abraham Lincoln. This post does not provide advice for specific individual situations and should not be construed as doing so.

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Post by Doc » Sun Jan 30, 2011 6:57 pm

Beagler wrote:Wellngton Fund's bond manager does not share your disdain for corporate bonds. Swensen's sentiments aside, why do think Wellington doesn't ascribe to your investing view?
I've been interested in the arguments on this subject over the past few months and the weight seems to be coming down on Treasuries for the long run. The camels straw seems to be the lack of co-variance with equities with Treasuries being the clear winner here. But what is missing from the debate is the size of the equity part of the portfolio. With a high equity portfolio Treasuries are the clear winner but with a high bond portfolio not so much. Once you get enough Treasuries to say equal the amount of equities any further increase doesn't buy you much in flight to quality situations.

All that being said, for now with the credit spread distorted by QE2 and its pals I'm putting short Treasuries in excess of my ~20% 1-3 ladder behind short corporates for any "new" money.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Post by grok87 » Sun Jan 30, 2011 7:31 pm

hsv_climber wrote:
grok87 wrote: Hsv_climber,
Well remember that that 0.7% average annual return difference is before fees. You need to pay a mutual fund fee with corporates to diversify whereas with treasuries you can just skip the fund and buy them directly.
But Mr. Grok wrote in the OP: "1) Buy Vanguard Bond Funds,"

So, lets compare apples to apples, since there is no difference in fees for VG bond funds between Investment-Grade & Treasury.
Good point- I suppose that was a bit confusing. To clarify, what I actually think is that one should stick to treasuries / tips for your bond allocation
-see for example my tip #1
http://www.bogleheads.org/forum/viewtop ... highlight=

and that it is more preferable to buy them directly rather than through a fund. If one does go for corporate or other bond funds that I think Vanguard is preferable to Fidelity for the reason I outlined.
hsv_climber wrote:
grok87 wrote: For the 38 years through 1/11/11 here are the returns: corporate index...8.28%
treasury..........7.96%

For that period the meagre 32 bps of outperformance would entirely have been lot to fees giving investors no compensation for all the extra risks of treasuries (2008 year, etc)
What index are you looking at? Obviously, we can look at different indices and derive different conclusions. Long Term Corporate & high-yield have never delivered the desired results.
OTOH, right now VG Short Term Inv. Grade fund (which is recommended by a few Boglehead authors) has a SEC yield of ~2% vs VG Short Term Treasury yield of 0.49%.
I'd say 1.5% extra yield is more than enough compensation for the risk of owning short term corporate bonds (for the record - VG ST Inv. Grade is ~12% of my portfolio).

Also, Swensen, with all of his bashing of Munis & Corporates, still recommends ultra-short Munis fund, also known to be VG Tax-Exempt Money Market Fund.

Cheers and please stop generalizing and switch to accurate numbers in your Tips.
I'm looking at the Barclays Corporate Bond index (formerly the Lehman Corporate Bond index). The data I posted is from Barclayslive- not sure if it is easy for others to see it. I don't really think it matters how far back you go. The data is not particularly controversial. Swensen's book was written pre-credit crisis and his point only becomes more strong once you include the credit crisis period.
For example, for the 10 years ending 12/31/2010 here are the average annual returns for various vanguard funds:
Vfitx (intermed treasuries)……..6.08%
Vipsx (tips)……………........………..6.79%
Vbmfx (agg bond index)…..…….5.57%
Vfiix (gmna’s)…………….........……5.82%
Vficx (invest. Grade)…….…....….6.36%

Again for this period investment grade corporate bonds beat treasuries by only 28 bps- a paltry amount given their extra risks.

Re the Vanguard Short Term Investment Grade fund, its benchmark is the Barclays 1-5 year credit index. The option adjusted spread for that index is currently 111 bps. Subtract off the 24 bp fund fee and you are left with a net spread of 85 bps or 0.85% over treasuries. Now it is important to realize that it is extremely unlikely that one will actually realize all of that 85 bps spread. Some will be lost to credit events such as bankruptcy, restructuring, leveraged buyouts etc.

cheers,
Keep calm and Boglehead on. KCBO.

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Re: Grok's tip #6/10: Be Aligned: Buy This, Not That!

Post by grok87 » Sun Jan 30, 2011 7:34 pm

Langkawi wrote:
grok87 wrote:
Langkawi wrote:
grok87 wrote:2) Buy Credit Union CDs not Bank CDs!
This claim needs a lot more data to support it. I realize that blind faith regarding the wholesomeness of credit unions is part of the Boglehead zeitgeist, but you should do better.
Well that was the headline- not the paragraph. I did mention PenFed specifically and discussed their policy on early withdrawals. Lots more discussion in this thread
http://www.bogleheads.org/forum/viewtop ... highlight=
cheers,
Well then your headline should have been "Buy PenFed CDs, not Bank or Credit Unions other than PenFed CDs".
Blind trust of (generic) credit unions is just as risky as blind trust of (generic) banks.
Good point- I agree one should always read the fine print. I do think, as a general principal, that one is less likely to get ripped off by a credit union than by a bank...
Keep calm and Boglehead on. KCBO.

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Post by grok87 » Sun Jan 30, 2011 7:36 pm

Doc wrote:
grok87 wrote: Hsv_climber,
Well remember that that 0.7% average annual return difference is before fees. You need to pay a mutual fund fee with corporates to diversify whereas with treasuries you can just skip the fund and buy them directly. ,
Come on Stranger, play fair.

iShares Intermediate Credit Bond Fund CIU expense ratio 0.20. :wink:

That's another whole half a percent.
Don't get me started on Bond ETFs! :)

I think Rick Ferri had a good post recently about why he doesn't use them- perhaps will someone will ferret it out and post the link...
cheers,
Keep calm and Boglehead on. KCBO.

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Post by grok87 » Sun Jan 30, 2011 7:37 pm

conundrum wrote:Thanks grok for your 6th installment. I appreciate all your work in sharing your tips with us.

Drum :sharebeer
Thanks Drum!
Keep calm and Boglehead on. KCBO.

grok87
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Post by grok87 » Sun Jan 30, 2011 8:14 pm

staythecourse wrote:Thanks Grok.

Your point all investors should know, but surprisingly the industry mesmorizes us to forget.

If anything this tip is another strong favor towards investing in index funds. Then you know what your investment is supposed to do. Any active management automatically invites manager risk. No thanks.
Yeah I agree. See for example my tip #3
http://www.bogleheads.org/forum/viewtop ... highlight=
cheers,
Keep calm and Boglehead on. KCBO.

hsv_climber
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Post by hsv_climber » Sun Jan 30, 2011 8:45 pm

grok87 wrote: Re the Vanguard Short Term Investment Grade fund, its benchmark is the Barclays 1-5 year credit index. The option adjusted spread for that index is currently 111 bps. Subtract off the 24 bp fund fee and you are left with a net spread of 85 bps or 0.85% over treasuries. Now it is important to realize that it is extremely unlikely that one will actually realize all of that 85 bps spread. Some will be lost to credit events such as bankruptcy, restructuring, leveraged buyouts etc.

cheers,
Why would someone pay 24 bp?
VCSH has E/R of 0.15%, VFSUX: 0.12%.

Now, assuming that someone is buying ST Treasuries directly... Are not you supposed to subtract the time that your money will be sitting in the MM fund earning 0.0001%? Or are you betting on a perfect timing that your 1-3 year Treasuries will be maturing exactly on the day of the next Treasury auction?

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Post by grok87 » Mon Jan 31, 2011 9:33 am

hsv_climber wrote:
grok87 wrote: Re the Vanguard Short Term Investment Grade fund, its benchmark is the Barclays 1-5 year credit index. The option adjusted spread for that index is currently 111 bps. Subtract off the 24 bp fund fee and you are left with a net spread of 85 bps or 0.85% over treasuries. Now it is important to realize that it is extremely unlikely that one will actually realize all of that 85 bps spread. Some will be lost to credit events such as bankruptcy, restructuring, leveraged buyouts etc.

cheers,
Why would someone pay 24 bp?
VCSH has E/R of 0.15%, VFSUX: 0.12%.

Now, assuming that someone is buying ST Treasuries directly... Are not you supposed to subtract the time that your money will be sitting in the MM fund earning 0.0001%? Or are you betting on a perfect timing that your 1-3 year Treasuries will be maturing exactly on the day of the next Treasury auction?
Good points. Re VFSUX (admiral class) remember that since this is not technically an index fund the minimum is still pretty high- $50 K or so.
Re the ETF (VCSH) I'm still a bit skeptical about bond ETFs. I know Rick Ferri had a post saying that he doesn't use them. Will try to find it, or perhaps someone else can post the link. From memory one issue is liquidity
cheers,
Keep calm and Boglehead on. KCBO.

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Post by Doc » Mon Jan 31, 2011 10:35 am

grok87 wrote:Don't get me started on Bond ETFs! :)

I think Rick Ferri had a good post recently about why he doesn't use them- perhaps will someone will ferret it out and post the link...
cheers,
I think Rick's thesis is based on trading costs and stale pricing. These items are important if you have to trade in adverse conditions like to re-balance during market upheavals. For the longer term investor what do I care if the price I pay for the ETF is 0.5% above the "true" NAV. If that premium persists I don't lose anything because I get it back when I sell. If it goes away I get an additional 5 bps of "e/r" over ten years. I can deal with that also. If it turns into a discount of 0.5%, which is not the historical trend, I get an additional 10 bps. Eh.

And what is the "true" NAV of a portfolio containing illiquid securities anyway. Is is some average value of the bid ask spread of its components, when the quotes may be very stale for some or is it the price a trader will pay for a share of the portfolio warts and all, perhaps with no trading costs if he is trading ETF shares for bonds in his own portfolio. Unless of course I happen to be a bank and have to mark to the (non-existent) market and therefore take down the world financial system. :twisted:


I don't know the answers but more important does it matter to my decision to avoid corporates and, if not, the decision to buy traditional funds over ETFs?

BTW I agree that high e/r mutual funds are likely to dip lower on the rating curve to make up the difference. But this has been made much harder to get away with since M* changed its bond rating system to a non-linear metric.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Post by grabiner » Mon Jan 31, 2011 10:18 pm

grok87 wrote:I think it is a flawed argument to say that the market always compensates all investors for all investment risks (not sure if you were saying that but let me take your argument, as I perceive it, to the extreme). Take foreign currency t-bills or just foreign currency. From a US investors perspective there is little return but enormous (currency) risk. I would argue that foreign currency tbills have no place in a US investors portfolio.
The market compensates investors for risks which affect everyone. Alignment for an investment is usually such a risk. Foreign-government bonds represent an increased risk to US-based investors, but a reduced risk to investors in that country or investors who spend money in that country, so there is no risk premium for the currency risk.

Meanwhile, long-term Treasury bonds, which have no alignment issues, represent a reduced risk for pension funds and insurance companies with their long-term fixed-dollar liability, so the risk premium is likely to be inadequate to compensate individual investors for the inflation risk.

And corporate bonds fit in both categories. The alignment issue affects everyone; the attraction for certain institutional investors may make corporates less attractive for individuals, if institutions prefer corporate bnonds to Treasuries.
Wiki David Grabiner

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Post by grok87 » Mon Jan 31, 2011 10:18 pm

exoilman wrote:Thanks for your effort and fine work. I hope the new kids on the block pay attention to your work.

Sam
thanks Sam.
Last edited by grok87 on Mon Jan 31, 2011 10:25 pm, edited 1 time in total.
Keep calm and Boglehead on. KCBO.

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Post by grok87 » Mon Jan 31, 2011 10:24 pm

Doc wrote:
grok87 wrote:Don't get me started on Bond ETFs! :)

I think Rick Ferri had a good post recently about why he doesn't use them- perhaps will someone will ferret it out and post the link...
cheers,
I think Rick's thesis is based on trading costs and stale pricing. These items are important if you have to trade in adverse conditions like to re-balance during market upheavals. For the longer term investor what do I care if the price I pay for the ETF is 0.5% above the "true" NAV. If that premium persists I don't lose anything because I get it back when I sell. If it goes away I get an additional 5 bps of "e/r" over ten years. I can deal with that also. If it turns into a discount of 0.5%, which is not the historical trend, I get an additional 10 bps. Eh.

And what is the "true" NAV of a portfolio containing illiquid securities anyway. Is is some average value of the bid ask spread of its components, when the quotes may be very stale for some or is it the price a trader will pay for a share of the portfolio warts and all, perhaps with no trading costs if he is trading ETF shares for bonds in his own portfolio. Unless of course I happen to be a bank and have to mark to the (non-existent) market and therefore take down the world financial system. :twisted:


I don't know the answers but more important does it matter to my decision to avoid corporates and, if not, the decision to buy traditional funds over ETFs?

BTW I agree that high e/r mutual funds are likely to dip lower on the rating curve to make up the difference. But this has been made much harder to get away with since M* changed its bond rating system to a non-linear metric.
Thanks- here's the Rick Ferri article
http://online.wsj.com/article/SB1000142 ... 95870.html
cheers,
Keep calm and Boglehead on. KCBO.

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Post by grok87 » Mon Jan 31, 2011 10:28 pm

grabiner wrote:
grok87 wrote:I think it is a flawed argument to say that the market always compensates all investors for all investment risks (not sure if you were saying that but let me take your argument, as I perceive it, to the extreme). Take foreign currency t-bills or just foreign currency. From a US investors perspective there is little return but enormous (currency) risk. I would argue that foreign currency tbills have no place in a US investors portfolio.
The market compensates investors for risks which affect everyone. Alignment for an investment is usually such a risk. Foreign-government bonds represent an increased risk to US-based investors, but a reduced risk to investors in that country or investors who spend money in that country, so there is no risk premium for the currency risk.

Meanwhile, long-term Treasury bonds, which have no alignment issues, represent a reduced risk for pension funds and insurance companies with their long-term fixed-dollar liability, so the risk premium is likely to be inadequate to compensate individual investors for the inflation risk.

And corporate bonds fit in both categories. The alignment issue affects everyone; the attraction for certain institutional investors may make corporates less attractive for individuals, if institutions prefer corporate bnonds to Treasuries.
agree- and also I think certain institutions prefer corporate bonds to equities
Keep calm and Boglehead on. KCBO.

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Post by kdmusic » Mon Jan 31, 2011 11:11 pm

Thanks so much for your work, Grok!

And now I"m alarmed. does your caveat about Fidelity apply even to Short Term treasuries? I've got Spartan Short-Term Treasury Bond Index Fund - Investor Class (FSBIX), as part of my bond allotment (very low ER), and now I'm nervous.

What say you? (or anyone else).

Keith

PS: now, having read this, really alarmed.

"Normally investing at least 80% of assets in securities included in the Barclays Capital 1-5 Year U.S. Treasury Index. Normally maintaining a dollar-weighted average maturity of three years or less. Engaging in transaction that have a leveraging effect on the fund."

WHAT? They are _leveraging_ in my ultra-safe short term treasuries? !!!

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Post by Abbey » Mon Jan 31, 2011 11:41 pm

Another thank you for the tips. I appreciate all the thoughtful posts and assistance here... and try very hard to follow all the nuances.
Abbey

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Post by grok87 » Tue Feb 01, 2011 8:16 am

kdmusic wrote:Thanks so much for your work, Grok!

And now I"m alarmed. does your caveat about Fidelity apply even to Short Term treasuries? I've got Spartan Short-Term Treasury Bond Index Fund - Investor Class (FSBIX), as part of my bond allotment (very low ER), and now I'm nervous.

What say you? (or anyone else).

Keith

PS: now, having read this, really alarmed.

"Normally investing at least 80% of assets in securities included in the Barclays Capital 1-5 Year U.S. Treasury Index. Normally maintaining a dollar-weighted average maturity of three years or less. Engaging in transaction that have a leveraging effect on the fund."

WHAT? They are _leveraging_ in my ultra-safe short term treasuries? !!!
Hi Keith,
Your welcome.
As per my post, it is the actively managed fidelity funds I worry about. I think their index funds (such as short term treasury index) are fine.
That being said, the 80/20 language does bother me a bit. I think that language might be in the vanguard funds as well though. I believe it may be geared toward some sort of Sec regulation- ie that funds have to be at least 80% invested in a manner consistent with their name/mandate. Take the vanguard s&p 500 fund. I think it actually holds 503 stocks- I believe because vanguard doesn't want to be an immediate forced seller when s&p moves stocks in and out of the index.
I think you can download the holdings of the fidelity funds to see if the are abusing the 80/20 rule. They did with their tips fund (as per my post above) but then that was not an index fund...
Hope that is at least somewhat reassuring...
Cheers,
Keep calm and Boglehead on. KCBO.

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Post by hsv_climber » Tue Feb 01, 2011 10:05 am

grok87 wrote: Thanks- here's the Rick Ferri article
http://online.wsj.com/article/SB1000142 ... 95870.html
cheers,
Ok, since you've brought up the issue with liquidity then lets talk about TIPS. What has happened to them during the financial crisis? :wink:

Bottom line, this Tip N6 takes many things out of context and can be more harmful than useful to investors. Generalization is never a good thing. Just like VG ST Inv. Grade ETF is probably less volatile than 10-year US Treasury Bond Fund or similar investments.

Other assumptions that you've made:
- VBS requires a minimum of $10k to buy treasuries directly. You complained that I've brought up VG ST. Inv. Grade Adm. shares. Please explain to me how can someone build a reasonable ST Treasury ladder @ VBS without paying brokerage fees? Or did you mean that someone should buy bonds only Fildelity? Then you should've just said so.

- "Credit Unions are better than Banks". This is so not true across the board. Just because something is non-profit, it does not make it to provide better products to the customers. This is just a huge fallacy. If it would've been true then Soviet Union would've still existed today. I also would like to know what Credit Union has provided better money market rates over the last 10 years than ING, Dollar/Emigrant Savings Bank, etc.

- "Buy companies that are "buying" back their shares, not "selling" in an IPO".
How does first part of your sentence is connected to the second part?
I agree about the IPO part, since it has been researched and it is true. But there is no proof that companies that "buy" back their shares produce better results in the long term. If you are aware of such research, please publish it.

In fact, google search returns quite the opposite articles.

http://www.minyanville.com/businessmark ... 0/id/26843
In reality, though, companies often use buybacks to offset share dilution through employee stock options or stock-based acquisitions, so there are no guarantees that buybacks boost EPS. Merely the announcement of the buyback can send shares higher, but there are no commitments to investors about when the plan will be executed, or at what price. Unlike dividends -- which must be paid out quarterly and are only lowered during particularly difficult times -- buybacks are dubious in nature and companies aren't required to follow through with them after they’ve been announced.

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Post by grok87 » Tue Feb 01, 2011 10:43 am

hsv_climber wrote:
- "Buy companies that are "buying" back their shares, not "selling" in an IPO".
How does first part of your sentence is connected to the second part?
I agree about the IPO part, since it has been researched and it is true. But there is no proof that companies that "buy" back their shares produce better results in the long term. If you are aware of such research, please publish it.

In fact, google search returns quite the opposite articles.

http://www.minyanville.com/businessmark ... 0/id/26843
In reality, though, companies often use buybacks to offset share dilution through employee stock options or stock-based acquisitions, so there are no guarantees that buybacks boost EPS. Merely the announcement of the buyback can send shares higher, but there are no commitments to investors about when the plan will be executed, or at what price. Unlike dividends -- which must be paid out quarterly and are only lowered during particularly difficult times -- buybacks are dubious in nature and companies aren't required to follow through with them after they’ve been announced.
thanks for the challenge!
Here is one such paper
http://papers.ssrn.com/sol3/papers.cfm? ... id=1365688

I think others are
Ikenberry, Lakonishok, and Vermaelen (1995 and 2000)
McNally and Smith (2007)

cheers,
Keep calm and Boglehead on. KCBO.

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Post by hsv_climber » Tue Feb 01, 2011 10:58 am

grok87 wrote: thanks for the challenge!
Here is one such paper
http://papers.ssrn.com/sol3/papers.cfm? ... id=1365688
cheers,
I can't access the paper, only the abstract. What does it say?

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Post by hsv_climber » Tue Feb 01, 2011 11:11 am

Found nice quote: http://www0.gsb.columbia.edu/faculty/jyu/buyers.pdf
For instance, Ikenberry, Lakonishok, and Vermaelen (1995) find for the U.S. stock market that the average abnormal four-year buy-and-hold return measured after the initial announcement of share repurchase is 12.1%. They also find that for low price-to-book stocks, where companies are more likely to be repurchasing shares because of undervaluation, the average abnormal return is 45.3%. For repurchases
announced by high price-to-book stocks where undervaluation is less likely to be an important motive, no positive drift in abnormal returns is observed. Ikenberry, Lakonishok, and Vermaelen (2000) find similar evidence for Canada and also that trades appear to be linked to price movements as managers buy more shares when prices fall.
In sum, these findings suggest that repurchases are consistent with firms intervening opportunistically much as speculators or market-makers would after the stock price falls significantly below fundamental value, and earning long-run abnormal returns for these trading activities.
Bottom line - buying firms, which repurchase their shares, is not much different than doing market timing or rely on these firms to be successful with their market timing.
Thus, your Tip N6 about that issue is WRONG. Unless of course you think that companies can actually be successful in their market timing. :wink:

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Post by grok87 » Tue Feb 01, 2011 11:19 am

hsv_climber wrote:
grok87 wrote: thanks for the challenge!
Here is one such paper
http://papers.ssrn.com/sol3/papers.cfm? ... id=1365688
cheers,
I can't access the paper, only the abstract. What does it say?
Hmm.. that's weird, sorry about that.
Try this link instead...
http://rfs.oxfordjournals.org/content/2 ... 9a2a667ec4
cheers,
Keep calm and Boglehead on. KCBO.

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Post by grok87 » Tue Feb 01, 2011 11:20 am

hsv_climber wrote:Found nice quote: http://www0.gsb.columbia.edu/faculty/jyu/buyers.pdf
For instance, Ikenberry, Lakonishok, and Vermaelen (1995) find for the U.S. stock market that the average abnormal four-year buy-and-hold return measured after the initial announcement of share repurchase is 12.1%. They also find that for low price-to-book stocks, where companies are more likely to be repurchasing shares because of undervaluation, the average abnormal return is 45.3%. For repurchases
announced by high price-to-book stocks where undervaluation is less likely to be an important motive, no positive drift in abnormal returns is observed. Ikenberry, Lakonishok, and Vermaelen (2000) find similar evidence for Canada and also that trades appear to be linked to price movements as managers buy more shares when prices fall.
In sum, these findings suggest that repurchases are consistent with firms intervening opportunistically much as speculators or market-makers would after the stock price falls significantly below fundamental value, and earning long-run abnormal returns for these trading activities.
Bottom line - buying firms, which repurchase their shares, is not much different than doing market timing or rely on these firms to be successful with their market timing.
Thus, your Tip N6 about that issue is WRONG. Unless of course you think that companies can actually be successful in their market timing. :wink:
thanks for the link- I'll read the paper when I get a chance...
Keep calm and Boglehead on. KCBO.

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Re: Grok's tip #6/10: Be Aligned: Buy This, Not That!

Post by grayfox » Tue Feb 01, 2011 11:37 am

grok87 wrote:
4) Buy common equities, not corporate bonds! Here is what David Swensen has to say about corporate bonds:

http://registeredrep.com/mag/finance_un ... _approach/#
David Swensen wrote:Corporate bond investors find the deck stacked against them as corporate management's interests align much more closely with equity investors' aspirations than with bond investors' goals. A further handicap to bond investors lies in the negative skew of the potential distribution of outcomes, limiting the upside potential without dampening the downside possibility...IBM illustrates the problem confronting purchasers of corporate debt. The company issued no long-term debt until the late 1970s, as prior to that time IBM consistently generated excess cash. Anticipating a need for external finance, the company came to market in the fall of 1979 with a $1 billion issue, at the time the largest-ever corporate borrowing. IBM obtained a triple-A rating and extremely aggressive pricing on the issue, which resulted in an inconsequential yield spread over U.S. Treasuries and (from an investor's perspective) underpriced call and sinking fund options. Bond investors spoke of the “scarcity value” of IBM paper, allowing the company to borrow below U.S. Treasury rates on an option-adjusted basis. From a credit perspective, IBM debt had nowhere to go but down. Fourteen years later, IBM's senior paper carried a rating of single A, failing to justify both the rating agencies' initial assessment of IBM's credit and the investors' early enthusiasm for IBM's bonds. Bond investors had no opportunity to lend to the fast-growing, cash-generative IBM of the 1960s and 1970s. Instead, bond investors faced the option of providing funds to the 1980s and 1990s IBM that needed enormous sums of cash. As IBM's business matured and external financing requirements increased, the quality of the company's credit standing eroded.
I don't think this generalization can be made into a simple rule that would be followed for all time under every economic condition. It depends on what interest rates are, valuations in the market, credit spreads, etc.

Suppose the Fed was buying up all the Treasuries under QEn and pushed Treasury rates down to 0.01% across the term structure.
Suppose stocks went up in a bubble to P/E10=40
But ST, IT, LT investment-grade were yielding 1, 3 and 5%
You would still hold equities and Treasuries?

Here is the investment grade spread over Treasuries today. Short term 1%, Int term 1.5% Long term 1.6%

Fund YTM

VFISX 0.8
VFSTX 1.8

VFITX 2.2
VFICX 3.7

VUSTX 4.1
VWESX 5.7

EDV 4.6
VCLT 5.7

And S&P500 with P/E10=23.83 has an expected return of 3.5% to 4% real. With 2.5% inflation VWESX expected return is 3.2% real.

So I would conclude that there is a good spread for the credit risk of investment grade over Treasuries. But there is not much extra return for all the risk of stocks over corporate bonds.

I think it is the job of investors to evaluate every offer and decide for themselves if they think there is sufficient reward for the amount of risk in the investment.

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Post by Naikansha » Tue Feb 01, 2011 3:51 pm

thanks for all the information and advice Grok, clearly written and presented so modestly, no promotion of books, websites and the like. I look forward to more.
Salut!

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Post by grok87 » Tue Feb 01, 2011 11:09 pm

Abbey wrote:Another thank you for the tips. I appreciate all the thoughtful posts and assistance here... and try very hard to follow all the nuances.
Thanks Abbey- if the nuances are confusing just ask away. Remember the only dumb question is the one you don't ask!
cheers,
Keep calm and Boglehead on. KCBO.

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Re: Grok's tip #6/10: Be Aligned: Buy This, Not That!

Post by grok87 » Tue Feb 01, 2011 11:21 pm

grayfox wrote:
grok87 wrote:
4) Buy common equities, not corporate bonds! Here is what David Swensen has to say about corporate bonds:

http://registeredrep.com/mag/finance_un ... _approach/#
David Swensen wrote:Corporate bond investors find the deck stacked against them as corporate management's interests align much more closely with equity investors' aspirations than with bond investors' goals. A further handicap to bond investors lies in the negative skew of the potential distribution of outcomes, limiting the upside potential without dampening the downside possibility...IBM illustrates the problem confronting purchasers of corporate debt. The company issued no long-term debt until the late 1970s, as prior to that time IBM consistently generated excess cash. Anticipating a need for external finance, the company came to market in the fall of 1979 with a $1 billion issue, at the time the largest-ever corporate borrowing. IBM obtained a triple-A rating and extremely aggressive pricing on the issue, which resulted in an inconsequential yield spread over U.S. Treasuries and (from an investor's perspective) underpriced call and sinking fund options. Bond investors spoke of the “scarcity value” of IBM paper, allowing the company to borrow below U.S. Treasury rates on an option-adjusted basis. From a credit perspective, IBM debt had nowhere to go but down. Fourteen years later, IBM's senior paper carried a rating of single A, failing to justify both the rating agencies' initial assessment of IBM's credit and the investors' early enthusiasm for IBM's bonds. Bond investors had no opportunity to lend to the fast-growing, cash-generative IBM of the 1960s and 1970s. Instead, bond investors faced the option of providing funds to the 1980s and 1990s IBM that needed enormous sums of cash. As IBM's business matured and external financing requirements increased, the quality of the company's credit standing eroded.
I don't think this generalization can be made into a simple rule that would be followed for all time under every economic condition. It depends on what interest rates are, valuations in the market, credit spreads, etc.

Suppose the Fed was buying up all the Treasuries under QEn and pushed Treasury rates down to 0.01% across the term structure.
Suppose stocks went up in a bubble to P/E10=40
But ST, IT, LT investment-grade were yielding 1, 3 and 5%
You would still hold equities and Treasuries?

Here is the investment grade spread over Treasuries today. Short term 1%, Int term 1.5% Long term 1.6%

Fund YTM

VFISX 0.8
VFSTX 1.8

VFITX 2.2
VFICX 3.7

VUSTX 4.1
VWESX 5.7

EDV 4.6
VCLT 5.7

And S&P500 with P/E10=23.83 has an expected return of 3.5% to 4% real. With 2.5% inflation VWESX expected return is 3.2% real.

So I would conclude that there is a good spread for the credit risk of investment grade over Treasuries. But there is not much extra return for all the risk of stocks over corporate bonds.

I think it is the job of investors to evaluate every offer and decide for themselves if they think there is sufficient reward for the amount of risk in the investment.
grayfox,
I agree with your estimate of 3.5%-4% real for the S&P 500 (I'm hoping for 4% myself).
I don't agree about the 3.2% real for VWESX.
Long term tips are yielding about 2.1%- so that is the expected real return for long treasuries- ties in nicely to your 2.5% inflation assumption.
The trouble is that no-one knows how much of the 1.6% spread will actually get realized and not eaten away by defaults etc. The trouble is a few defaults can really kill your corporate bond returns since in bond investing your upside is so capped. This is what swensen means by the skewness of bond returns- he means skewness in a bad way!

Take a look at the data- over the past 10 years, avg annl returns were:

Intermed treasury...5.97%
intermed inv. grade..6.23%

long term treasury....6.13%
long term inv. grade..6.64%

so you realized excess returns of 26 bp on the intermed side and 50 bps on the long term side. I think spreads at the beginning of the 10 year period were around 200 bps. So you realized only a fraction. 26 bps and 50 bps are not that material especially since you are comparing to treasury fund. You could buy the treasuries yourself and outperform the funds by 20-30 bps by skipping the treasury fund expense ratio.

cheers,
Keep calm and Boglehead on. KCBO.

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Post by grok87 » Tue Feb 01, 2011 11:22 pm

Naikansha wrote:thanks for all the information and advice Grok, clearly written and presented so modestly, no promotion of books, websites and the like. I look forward to more.
Salut!
thanks Naikansha!
Keep calm and Boglehead on. KCBO.

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Post by Naikansha » Wed Feb 02, 2011 11:29 am

Grok, these are terrific. I like the way each original tip opens up such good conversations. How about a tip on REITs?

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Post by grok87 » Wed Feb 02, 2011 11:02 pm

Naikansha wrote:Grok, these are terrific. I like the way each original tip opens up such good conversations. How about a tip on REITs?
THanks
Good idea on the Real Estate- I'll try and squeeze it in there...
Keep calm and Boglehead on. KCBO.

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