Bespoke Investment Group’s 2010 roundtable discussing asset class expectations

The 2010 Bespoke Roundtable is out, and as always, they’ve done some interesting work. I think it’s extremely insightful. the link to their full post is here: http://bespokepremium.com/roundtable/

They present the aggregated “up or down” predictions very clearly in this table:

I have a few quick comments:

-The up/down prediction for the S&P 500 is mostly “up” with only a couple “experts” disagreeing. Who knows? No one has EVER been able to successfully profit from trying to time the market over a reasonable time period. There are a zillion studies that reach that conclusion, and my summary of the Morningstar book has their conclusions based on their data that confirms the same thing. SO what do you do? Well, I think  you try to capture potential upside from equities by having some long-equity exposure, but you keep long-equity allocations to a minority of your portfolio, and instead spread your assets across multiple asset classes, with a preference for long/short strategies, and you try to generate current income (all the while trying to focus on uncorrelated investment returns).

-Long bonds: everyone polled agreed that they should have a negative return in 2010. There could be multiple reasons: rising interest rates, higher default rates, less attractive yields/valuations…the list goes on and on. This is why I prefer munis that are insured and through closed end funds that are trading at a discount: you reduce your tax liability and you reduce your default risk. The rising interest rate or rising inflation scenario is why I like floating / variable rate debt. You get income from being long debt, but the interest payments increase in size as overall interest rate levels rise.

-Junk bonds: not for me. I don’t know of any consistent and low-risk funds that have demonstrated success in the junk bond / high-yield debt space that I would consider for my portfolio at this present time. I say “at this present time” because entire asset classes can occasionally get cheap enough that you don’t really need to worry about the skill of a fund’s active asset management, but given the recent run-up in junk bonds and the uncertain default risk trend I just can’t stomach purchasing high-yield debt now when I can get similar income generation from other asset classes and can lower the tax impact by going with municipal bonds. Sure, junk bond prices can rise much more when they do rise versus munis or other higher-credit quality debt, but the reason junk bonds rally is usually because of optimism about near-to-medium term economic prospects, and I think that the best case scenario is already reflected in the massive recent appreciation of both junk bonds and equities.

-Gold & Oil: The roundtable has mixed expectations for the next year. I think that’s why I prefer a long/short commodity strategy and a long-term investment horizon. Commodities are an important asset class to have in your portfolio, so you don’t want to forget to have some exposure, even if it’s only a little. If inflation does become an issue, regardless of what macroeconomic demand is, then commodities will benefit.

-The US Dollar: The roundtable is uncertain and so am I about what the Dollar will do in the next year. Over the medium-to-long-term, however, I have very high conviction that the US Dollar will continue to lose its purchasing power and will continue to decline against other currencies, just like it has done over the last 50+ years. This is why I like an absolute-return strategy currency allocation. Currencies are a very, very tricky asset to trade profitably, and I would advise non-expert investors to let the experts handle it and go with a good mutual fund.

-China: Who knows what happens. I will probably always keep a portion of my assets in Chinese equities (I hold HAO), although I have recently trimmed my allocation after the very large run up in Chinese equity prices. Regardless, China has much more attractive prospects for equity investment returns over the long-term than the US does, so I will always hold some China and will look to buy more over time when the overall indexes decline.

Strategies For Uncertain Times: Floating or Variable Debt (plus commentary on shorting treasury)

Overview: Bottom line, they do well in a rising rate environment and are negatively-correlated with long-bond positions. Interest rate paid on fixed income securities held by the fund is reset/floats with overall interest rate levels. Higher interest rates = higher income from the same assets. Credit quality is key. As interest rates are virtually certain to increase in the future (they can’t decline much further as the downside boundary is limited to 0.0%), I believe that floating debt is preferable to traditional fixed income (either US government treasuries or US corporate debt). That said, inflation still eats away at the real return from any investment, which means inflation in the US would hurt floating rate debt real returns like they would for almost every investment. Many ARPS (auction rate preferred stock) securities are issued by financial institutions, and they are hardly beyond doubt at the moment from a credit default perspective. I prefer to avoid high concentration of actual assets/holdings from financial institutions or in the financial sector in general, because the downside risk of permanent loss of capital is way too large given their typical yields. Accordingly, it’s very helpful to look at the number of holdings that a fund has and the concentration of those holdings as a way to get a handle for the risk of default from a tiny number of holdings severely hurting overall returns.

• Open-end mutual funds: There are plenty but only but CEFs at a discount
• CEFs: THERE ARE LOTS OF THEM, ONLY BUY AT DISCOUNT
  • FCM:
  • FCT:
  • GFY:
  • JFR:
  • EVF:
• ETFs: None that I know of.

Other Notes:

• Commercial loans are typically senior and usually secured by specific collateral (AR, inventory, equipment, real estate). Bank loans are typically non-financial-industry corporate loans.
• Auction-rate preferred securities (ARPS) are typically issued by financial companies for their own funding needs.

Short Treasuries

Overview: Another similar strategy is just shorting treasuries. The reason I prefer being long variable rate debt is because US treasury yields are subject to numerous technical factors that make fundamental-based strategies risky for reasons that often cannot be foreseen or hedged at a reasonable cost. Rising inflation and interest rates hurt treasury security prices. Both interest rates and inflation will rise over the next couple years. An alternate way to play rising inflation is to be long commodities, which I describe in another post.

• Open-end mutual funds:
  • RRPIX: 125% short LT treasuries
  • RYJAX: Inverse of LT treasuries
• ETFs: there are plenty of them, check out Bloomberg.com for a great list
  • TBF: Short 20 year treasuries

Strategies for Uncertain Times: Commodities

Overview: I’m talking about the actual commodity futures, not equities of companies involved with commodities, and also preferably on a long/short basis. Commodities have a negative 0.04% correlation with equities over the last 10 years. Commodities CAN be an uncorrelated play on basic raw materials & energy, which may move independently of equities although they are macro cycle dependent. Commodities are positively correlated with inflation, which will increase. I prefer long/short commodity strategies to long-only b/c the risk of draw-down is less when commodities are not in a strong uptrend. Low distributions from actual-commodity funds (as opposed to equity-focused funds) means it’s probably best to hold in a taxable account if you plan on holding for longer than one year. Remember, equities of natural resources companies have a VERY high beta versus the S&P over the last 10 years, so you don’t get the diversification benefit as well as if you hold actual commodity futures.

• Open-end mutual funds:
  • PCRDX/PCRAX: Pimco commodity real return fund
    • Invests partially in another Pimco actual commodity fund
    • 29% std dev and a 0.80 beta vs. S&P
  • HACMX: SAME as PCRDX but with lower fees, same mgmt team
  • CRSAX: Credit Suisse Commodity Return Strategy (long-only)
    • 0.90% annual fee
    • 23% std dev and 0.58 beta vs. S&P
  • RYLBX/RYLFX: Rydex Long/Short Commodities Strategy
    • Based on 12 month price trend following model
    • 4.75% load, 2% annual fee (estimated fees, it’s brand new, but still too high)
    • Can be long or short any commodity, can be net short depending on model outcomes
• ETFs:
  • GRES: Global resources, hedged. All commodity sectors but only through equity positions. Short the index against long equity positions. Does not hold actual commodities.
  • LSC: ELEMENTS S&P Commodity ETN
    • Long/short actual commodity futures ETN based on price trend following.
    • Direction of long/short based on 7 month exponential moving avg
    • 6 sectors, 16 actual commodities. Fixed weight to sectors, always long energy
    • Rebalanced monthly
    • Only 0.75% annual fee
  • RJI: Broadest long-only actual commodity ETF, followed by DJP and then GSG
  • IGE: North American Natural Resources
    • Only holds equities of natural resources companies
  • HAP: Hard Asset Producers
    • Only holds equities of hard asset companies, 60% international

Other Notes:

• Equity-based natural resource funds have VERY high beta vs. S&P, so DON’T buy them
• L/S commodity funds have a NEGATIVE beta vs. S&P
• Agribusiness is popular subset of this (like Potash fertilizer, etc).
  • MOO is the active agribusiness ETF
  • PAGG: PowerShares Global Agriculture ETF