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As someone once said, if there’s no conflict, there’s no interest

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Fiduciary (noun): a person to whom property or power is entrusted for the benefit of another.

Recently, the “fiduciary rule” has been in the news.  As the home page on our website says “We hold ourselves out as professionals and fiduciaries meaning that it is our legal and ethical duty to put your interests ahead of our own.”  We hope that is clear to you.

What’s clear to us is that a lot of investors have more trust in their advisors than is warranted.  Brokers and advisors are not always required to put their clients’ interests first.  There have been unsuccessful efforts to change this.  As reported by CNBC:

The 5th Circuit Court of Appeals ruled on March 15 that the Labor Department overstepped its authority by creating the so-called fiduciary rule, parts of which went into effect last year. In general, the rule requires advisors and brokers to put their clients’ interests before their own when advising on retirement accounts such as 401(k) plans and individual retirement accounts.

Advisors and brokers do not have to put their clients’ interests first.  In our opinion this can lead to higher fees and less appropriate investments.

If you have questions, let us know. If you know someone who could benefit from our services and fiduciary standard, we’d like to know that too.

 

Home Country Bias

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What is home country bias? How can it hurt your investment performance? How do you recognize it? How can you neutralize it?

At the time of this writing, we expect higher returns from non-US stocks than U.S. stocks. We are writing this out of concern that home country bias may hurt investors’ performance. We stop short of saying that investors shouldn’t be biased; rather, we believe investors should be conscious of home country bias and comfortable with its effects if they are going to be biased.

What is home country bias (HCB)? It’s the tendency for investors to prefer investments in their domestic market. For example, U.S. investors tend to prefer U.S. investments.

How prevalent is HCB? According to a study by Vanguard, U.S. investors have about 80% of their equity investments in the U.S. despite the fact that U.S. equities are only about 50% of the global equity market. This is also true globally: Australians allocate 66% of their investments to their home country versus a global market weight of 2%; in Japan it is 55% versus 7%; in the U.K.it is 26% versus 7%.

Why might a HCB hurt you? When U.S. stocks underperform markets in other countries, over-weighting U.S. stocks will detract from your performance. That’s pretty obvious. Some will also argue that global diversification is less risky than concentrating on your home market. That may be, but the advantage is small given that the U.S. market has historically tended to exhibit less volatility than foreign markets. Of course, HCB helps your portfolio when the U.S. market is outperforming.

Here are the ten year return expectations from Research Affiliates as of July 31, 2017:

Market

 Expected
Return
U.S. Large (S&P 500) 2.6%
International Developed 6.9%
Emerging (a.k.a. Developing) 8.7%

International developed includes countries such as Germany, France, Japan and the U.K.  Emerging includes China, Russia and Brazil.  Source: Research Affiliates

A global stock investor holding 50% US, 40% international developed, and 10% emerging (which is close to the global market value weights) would have a 5.3% expected return as compared to an investment in the S&P 500 with a 2.6% expected annual return.  If the investor has 60% of their portfolio in equities, they would expect an additional 1.6% annually.  This increased return would add about 15% to an investor’s portfolio (before taxes and inflation) over the 10 years due to compounding.

Why a HCB might be right for you?  Even if the absolute return and risk is expected to be lower, you may still choose to tilt toward the U.S. for a variety of reasons.  Doing so may make you feel better or safer or satisfy patriotic wishes.  While you may not actually be safer with your bias, you may feel that way just as people may feel safer in a car than a plane.

How to tell if you have a home country bias?  If you compare your performance to the S&P 500 or Dow indices without consideration of international stocks, you clearly have a bias.  Technically and mathematically speaking, you have a bias if your weight to U.S. stocks exceeds the weighting of U.S. stocks in the global market.

Why only discuss the bias related to equities and not fixed income?  In our case, we use fixed income mainly to control risk. Investing in U.S. bonds avoids currency risk.  Additionally, many of our clients are taxable and municipal bonds offer tax advantages that foreign bonds do not.  We will consider non-US fixed income in portfolios, but generally these are substitutes, at least to an extent, for equities.

What should an investor do?  Our recommendation is to consciously select a benchmark that reflects your preferences.  If your preference is for the best investment performance and you permit global investments, then your equity benchmark should be a global stock index such as the MSCI All Country World Index (ACWI).  At this time, the exchange traded fund based on this index (the ticker is ACWI) has a weighting to the US of about 50%.  If you are uncomfortable with this weight, then you can select a blend of indices that represents the U.S. (e.g., the S&P 500 or our preference the Russell 3000) and an index of non-U.S. stocks (e.g. ACWIxUS).  For example, one might choose an allocation of 75% to the Russell 3000 and 25% to the ACWIxUS.  After establishing a benchmark, one can then tilt their portfolio according to one’s expectations about the markets.

How to make something from nothing (or even less)

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You have two investment options.  You can invest in cash which returns 0% each day, and you can invest in a stock which on any given day has a 50% random chance of losing one-half of its value and a 50% chance of doubling.  How should you allocate your money between the two?  To be clear, over time if you buy and hold the stock, you expect a zero growth because ½* 2 = 1

It may seem that there is no way to make money, but that wouldn’t make for an interesting post.  In fact, you could expect to make about 6% per day on average if you could trade without transaction costs.

Put ½ your money in cash and ½ in the stock and rebalance to that proportion every day.  You would expect that on half of the days the stock will go down and your portfolio will be worth 0.75 of its previous value.  This is because you would have the half that you put in cash plus one-half of the half you put into stocks.  On the days the stock goes up, your portfolio will be worth 1.5x as much because you will have the half you invested in cash plus 2x the half you put in stocks.

Thus, every two days we’d expect the portfolio to grow by a factor of 0.75 * 1.5 = ¾ * 3/2 = 9/8.  Over n days, the growth factor would be (9/8)^(n/2).

Thus if you started with $1, you’d expect to have $361 over 100 days.

Even if both your investment choices are lousy, there still might be a way to make money. Imagine your investment choices are stocks A and B.  On any given day there is a 50% random chance that A will only be worth 10 cents on the dollar – it loses 90% of its value.  There is a 50% chance it will double.  Thus over time, we’d expect to lose money if we only held that stock. In fact, after two days, we’d expect to have twenty  cents on the dollar.  That doesn’t sound good.  Stock B is exactly the same except when A loses 90%, B will double and when A doubles, B loses 90%.  So now we have 2 lousy individual investments (but the good news is they move out of synch).   Let’s split our money between the two and see what happens.

Each day our portfolio will grow by a factor of  (0.5 * 0.1) + (0.5 * 2) =  1.05.  Yes, even though both stocks on average lose money each day, we would make 5% each and every day.

In the absence of transaction costs, one can make money on volatility just by rebalancing.  You can even make more than the best performing investment.  The tough question is why aren’t we all rich?

While this is not investment advice and is for entertainment / educational purposes, it does suggest the benefit of diversifying and rebalancing.

If you are fascinated by this and you like math, you may want to read the paper “Universal Portfolios” by Thomas Cover.

Market Reaction to the Election

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In this post we look at how markets have reacted to the election of Donald Trump and a Republican controlled House and Senate on November 8th. The reaction has been interesting and generally positive. It also highlights one of beliefs at Red Tortoise which is that markets predict the economy better than the economy predicts the markets.

Global Stocks

First, let’s look how stocks around the globe have performed before and after the election. For this we’ve picked three funds.
• U.S. stocks are represented by the iShares Core S&P 500 ETF (IVV)

• Stocks of developed international markets as represented by the iShares MSCI EAFE ETF (EFA) where EAFE is an acronym for Europe, Australia and Far East.

• Stocks in emerging markets represented by the iShares MSCI Emerging Markets ETF (EEM)

Election day (the vertical line) is the reference date and all the returns are indexed to zero so that the performance before and after can be visualized easily. None of the markets show a trend in the month leading up to the election. Since the election, the U.S. market has moved up with the developed and emerging markets have declined. From this it seems that the market might be expecting a pickup in the U.S. economic activity. However on the surface this isn’t helping other markets.

globalstocks
Source: Yahoo Finance

Interest Rates

If economic activity is going to pick up then we’d expect interest rates to rise and that is what we see in the following chart.If economic activity is going to pick up then we’d expect interest rates to rise and that is what we see in the following chart.

interest rates
Source: Federal Reserve

The Dollar

A country’s currency rises when there is demand for that currency by people wanting to consume its products and services or invest there. Since the election the U.S. dollar has appreciated strongly against the Mexican peso. It’s moved up relative to a trade-weighted basket of major currencies, but declined against the Euro.

dollar
Source: Federal Reserve

Inflation

A stronger economy and rising interest rates might be associated with inflationary pressures. A market-based measure of the expected inflation rate can be inferred by taking the difference between the yield of a nominal Treasury bond and an inflation-linked bond of the same maturity. As the chart shows, inflation expectations have ticked up 0.1% to 0.2%.

inflation
Source: Federal Reserve

 

Disclaimer: Red Tortoise cannot guarantee the accuracy, or completeness of any of the information in this post.  Red Tortoise shall not have any liability, contingent or otherwise for the accuracy or completeness of the information or for any decision made or action taken by you in reliance upon the information herein.  

Trump – What Worries Me

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Summary: Trump has promised to curb free-trade; he has unilateral power to do so; and the results could be disastrous for the economy.  One may want to reduce equities now or be prepared to do should he follow through with his plan.

Trump campaigned with a 100-day action plan which includes the following:

★ FIRST, I will announce my intention to renegotiate NAFTA or withdraw from the deal under Article 2205.
★ SECOND, I will announce our withdrawal from the Trans-Pacific Partnership.
★ THIRD, I will direct the Secretary of the Treasury to label China a currency manipulator.

Trump is a mercantilist who rebukes economic theory and sees trade as a zero sum game where those who import more lose to those who export more. He looks to make the U.S. a winner giving little weight to the benefits of trade for U.S. consumers and geopolitical alliances.
The President appears to have substantial unilateral power when it comes to restricting trade.

The International Emergency Economic Powers Act (“IEEPA”) grants the President authority to take actions to restrain trade that would not be subject to court review in response to unusual and extraordinary threats to the economy of the United States. It’s conceivable Trump might try to use the powers under the IEEPA.

Section 201 of the Trade Act of 1974 permits the President to grant temporary import relief by imposing duties or barriers on goods entering the United States.

What would happen if Trump follows through on his promises? The most famous case study would be the Smoot-Hawley Tariff which passed the House in May of 1929, the Senate in March of 1930 and signed by Hoover in June of that year. It’s not fair to say that it caused the Great Depression, but it probably had an important role along with the stock market crash, overproduction and a tight monetary policy. Exports fell from $7 billion in 1929 to $2.5 billion in 1932. Farm exports were slashed to a third of their 1929 level by 1933 causing defaults and strains on the banks. I’m not forecasting the magnitude of the drag on the economy, but am saying there would be a drag and it could be large. Also, we would expect to pay more as import prices rise.

The prospect of a trade war and the impact on the global economy suggests a reduction in equity exposure. On the other hand the S&P 500 stock index has risen with the news of Trump’s election. I respect markets deeply and the market’s behavior should give one pause. My plan is to be prepared to respond to words and actions suggesting the Trump administration is going to live up to his 100 day plan.

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