Since this thread had not seen fit to die yet ...
Doc wrote:Kevin M wrote:It depends what you mean by "has just not come home to roost". If you mean that we haven't seen a negative nominal return for intermediate-term Treasuries for the 9-year period, then sure, but that's not unusual.
Since this is the only part of my last reply you responded to, can I assume that you've accepted the refutation of your other points, such as the yield curve having been static over the last nine years, and "rates" having been held at 0% by the Fed?
Doc wrote:No I mean that intermediate term Treasury yields have not gone up substantially over the past several years even though many if not most think that these rates will rise. That term risk has not come home to roost.
OK, but this is approximately the same thing, and again, is not unique to the last nine years compared to the last 35 years. What I have a problem with is your characterization of the last nine years as somehow unique in a way that standard measures of risk and risk-adjusted returns don't apply for some reason.
We saw term risk show up in 2013, and the drawdowns were proportional to duration (term risk), as we'd expect. Whether you look at drawdowns or standard deviation of annual returns, the performance of bonds over the last nine years give us just as much of a clue as to a potential distribution of future returns as any other 9-year period.
In fact there is one poster on this board who promotes using CD's with low early withdrawal penalties as one of the reasons to prefer CD's over Treasuries if/when interest rates rise. Oh gee whiz, that poster is you isn't it.
So are you arguing with me or with Kevin.

Perhaps you can be more specific, but I don't see any inconsistencies. There are two reasons I have preferred direct CDs to bonds in recent years (although I continue to hold some bonds): 1) a yield premium that has averaged 115 basis points over Treasuries of same maturities over the last 6.5 years, and closer to 150 basis points over the last two years; 2) the early withdrawal options with low early withdrawal penalties (EWPs) that significantly reduces term risk compared to Treasuries of same maturity. How is that inconsistent with arguing that term risk basics for bonds have not been unique over the last nine years compared to any other time?
Using variance as a risk measure in a stable yield curve environment may be a useful metric even for Treasuries. But it ignores term risk in a changing yield curve environment unless the time period you are using covers many yield curve cycles.
Now I'm confused. I thought you were arguing that variance and Sharpe ratio were
not applicable to the last nine years because the yield curve has been static (which is not the case), but now you're arguing that variance
is a useful risk metric in a stable yield curve environment?
At any rate, I agree that variance (or standard deviation) of annual returns is not directly applicable to holding periods of longer than one year. However, both theory and empirical evidence support the notion that long-term variance is proportional to shorter-term variance, so SD of one year returns should provide us with a sense of the distribution characteristics of expected returns for longer periods. This is at least the case for a bond fund or rolling ladder of bonds, with no maturity date.
So whether we look at SD of annual returns, maximum drawdowns during periods of rising interest rates as we saw in 2013, or simply average duration, we should come to the conclusion that longer-term bonds are riskier than shorter-term bonds, and that funds with no credit risk and the about same duration should perform about the same. And that's exactly what we see for the two funds the comparison of which started this line of discussion. I come to the same conclusion whether I look at at last nine years or the last 100 years.
Back in the days when the Sharpe ratio was widely discussed people often took total bond market (10 yr Treasury ?) as the riskless asset when the original CAPM model was I believe, 4 wk T-bills. Now we are trying to apply the Sharpe ratio to intermediate term Treasuries. I have trouble with that application.
I can't see any justification for using a rolling bond ladder or bond fund with a duration of five or more years as a riskless asset in any circumstances. A 10-year Treasury is the riskless asset in nominal terms for a 10-year holding period. A 1-year Tbill is the riskless asset for a 1-year period, and a 1-month Tbill is the riskless asset for a 1-month period (all in nominal terms of course).
Of course it would not make sense to calculate Sharpe ratio for a rolling ladder of intermediate-term Treasuries if a rolling ladder of intermediate-term Treasuries was considered to be the riskless asset, but it's not.
Most of the applications of CAPM I've seen have an implicit holding period of one year, since it's typically annual returns that are used in the analysis. This is what we seen in Portfolio Visualizer. And of course the Sharpe ratios are based on one-year returns and SD of one-year returns. Again, I agree that Sharpe ratios based on one-year returns aren't directly applicable to 5-year or 10-year or 30-year returns, but again, there ought to be some proportionality there.
If I want nominal certainty for a 5-year holding period, I'll prefer a 5-year Treasury or CD held to maturity over a bond fund with an average maturity of five years, since either of the individual securities is riskless in nominal terms for a 5-year holding period. Of course I'll prefer the CD to the Treasury if I can earn a decent yield premium.
Of course I'd prefer a 5-year TIPS if I want 5-year certainty in real terms, but with a yield premium over nominal Treasury of 100 basis points, I'm willing to live with the additional uncertainty for this relatively short time period. And the early withdrawal option of the CD provides an additional hedge against unexpected inflation, since nominal rates are likely to increase with inflation.
Back to the main point, I think PV uses 1-month Treasury as the riskless asset. It could be argued that 1-year Treasury is more applicable, since all the other components of the Sharpe ratio calculation are based on annual returns, but this is a relatively minor point. Whether you subtract the risk-free rate from the asset return in the numerator or not, you basically have a ratio of return to SD of returns. I don't think the fact that the risk-free rate has been close to 0% for the last nine years has huge significance. We see a similar pattern of Sharpe ratios increasing with duration for 1978-2008 as we do for 2009-2016.
My original position that the active and index funds under discussion did not having the same risk was based on my misconception that they had significantly different durations. I was wrong. I misinterpreted a comment in some report because I thought they used the same bogey which they don't.
It's good you figured that out, since it resolves what otherwise would be a bit of a puzzle, and we might be having an even more interesting discussion.
There is no issue here as far as I am concerned.
Not if we agree that there's nothing unique about the last nine years that should cause us to abandon well-understood risk and expected return measures for other than the shortest-term bonds (for which the Fed has not allowed an expected inflation component to be built into the yields).
Kevin