The “All-in-One Fund” With a Twist

June 16, 2010

Morningstar’s Christine Benz recently made the case for the “All-in-One Fund” that has the ability to allocate among multiple asset classes. According to Benz, the most compelling reason to choose such a fund:

Finally-and I’d say this is the key reason why it’s a mistake to avoid all-in-one allocation funds-flexibility can be an important advantage for talented managers who choose to take advantage of it. In a recent column I noodled on what constitutes a core holding, and Morningstar.com users chimed in with their own take on this topic. The mother of all core investments, as one poster argued, is one that has the freedom to go wherever opportunities beckon. [My emphasis added]

One of Benz’s favorite funds in this category is the $40 billion BlackRock Global Allocation Fund (MDLOX.) This value-oriented fund, has generated excellent returns over time. It also happens to only have a correlation of 0.44 to our own “All-in-One Fund”- our Global Macro portfolio. Mixing a good value strategy with a good relative strength strategy may allow you to increase your returns and decrease the volatility as can be seen in the efficient frontier below:

(Click to Enlarge)

A 50/50 mix between the Global Macro strategy and the BlackRock Global Allocation fund resulted in higher returns and less volatility than either of the strategies independently. The S&P 500 only had a 0.29% annualized return over this same time period and had an annual standard deviation of 17.95%.

To receive the brochure for our Global Macro strategy, click here. For information about the Arrow DWA Tactical Fund (DWTFX), click here.

Click here and here for disclosures. Past performance is no guarantee of future returns. Source of returns for MDLOX is Yahoo! Finance.

Leave a Comment » | Relative Strength and Value | Permalink
Posted by Andy Hyer

Bonds: Upon Further Review

June 16, 2010

One of the effects of PBSS (Post-Bear Stress Syndrome) has been the flood of money into fixed income over the last couple of years. According to the Investment Company Institute, from October of 2007 through May 2010 there have been net inflows into bond funds of $230 billion while there have been net redemptions from equity funds of $553 billion. After going through two major bear markets in 10 years, investors want less risk. It is only understandable that investors have reacted this way. Over the last ten years, investor’s focus has steadily moved from investing in order to achieve long-term financial goals, like providing for a comfortable retirement, to a focus on avoiding short-term portfolio losses. However, the further that we get from the last bear market the more investors are going to remember the whole reason for investing in the first place. Once again, they will start looking at their current assets and deciding whether or not they will have enough money to maintain their lifestyle throughout their lives. When those shifts in focus start to take place, more and more investors are going to take a closer look at their current asset allocation and wonder if their giant bond portfolio is going to get the job done.

For many investors today, their view of bonds has been colored by the performance of this asset class over the last thirty years. Over this period of time, the wind has been at the back of bond investors as the yields have steadily declined from their peak in 1981 (bond yields and prices move inversely).

(Click to Enlarge)

Data courtesy of The Leuthold Group.

However, the experience of fixed income investors was something entirely different prior to 1981. As seen in the chart above, from 1957 until 1981 bond yields trended higher (and bond prices declined.)

The chart below shows the real (net of inflation as defined by CPI) return of the 10 year Treasury Note Total Return Bond Index from 1969 to April 2010.

(Click to Enlarge)

Data courtesy of The Leuthold Group.

A lot of investors may be surprised by this chart. All of a sudden bonds don’t seem quite so safe when considered in the context of real (after inflation) returns. I have real return data for the 10-year Treasury Note Total Return Index from December of 1969 through April 2010. From December 1969 through December of 1981, when yields were rising, the average 12 month real return of bonds was -3.16%. From January 1982 through April 2010, when yields were declining, the average 12 month real return of bonds was 7.18%. The question now is what comes next for bonds. They have been excellent for 30 years, but we have also seen periods where they were dreadful.

Harold Parker, one of our senior portfolio managers, entered this business in the late 1970s and offers some perspective on investor sentiment towards bonds both then and now:

One of the problems with getting older is that you start to lose some of your old friends. I have been experiencing that in my life. The friends who are being called back to their maker were born in the early 1980′s and one by one they are disappearing. These friends, these remnants of a bygone era, are not people; they are Treasury bonds. They are some of the last survivors of a time when double digit yields on long term Treasurys were there for the taking. Locking in a “risk free” double digit yield for decades seems so attractive now, yet investors could hardly be persuaded to take long term bonds by anything short of a gun.

It was a different world when these old friends were born. Bonds had been in a decades-long bear market. Inflation was running at double digits. The conventional wisdom was that nobody in their right mind would buy a long-term bond. Real estate and gold were booming and it took yields of over 13% to entice buyers.

But alas, our old friends are leaving us. As they leave, we find ourselves in a very different world. We have enjoyed a decades-long bull market in bonds as interest rates have declined to levels not seen since our grandparent’s days. Inflation rates are low and and most non-bond asset classes look volatile and risky.

Nobody in their right mind would buy anything but a bond now.

With interest rates and inflation at rock bottom levels, every investor should be asking the question of what comes next for bonds. In order to achieve long-term financial goals, and with risk management still a priority, I would suggest that there are much better investment options than bonds right now. One such option would be our Global Macro strategy (available as a separately managed account and as the Arrow DWA Tactical Fund - DWTFX). This strategy can invest in bonds, but only does so when the relative strength of bonds is strong. The strategy can also invest in U.S. equities, international equities, currencies, commodities, real estate, and inverse equities.

The chart below shows the allocation of our Global Macro strategy to fixed income over the period of its testing and live performance. You will notice that the exposure to fixed income tends to pick up during major bear markets, but is reduced or eliminated when there is better relative strength in other asset classes.

(Click to Enlarge)

Investors have no desire to jump from the frying pan and into the fire in their search for safety. Yet, that may be exactly what they are doing by piling into fixed income right now. I would suggest that a global tactical asset allocation strategy would give them the comfort of knowing that it can be allocated very conservatively at times, but it will systematically move to other asset classes when needed.

To receive the brochure for our Global Macro strategy, click here. For information about the Arrow DWA Tactical Fund (DWTFX), click here.

Click here and here for disclosures. Past performance is no guarantee of future returns.

2 Comments | Markets, Tactical Asset Alloc | Permalink
Posted by Andy Hyer

Gentlemen Prefer Bonds?

June 16, 2010

According to CNBC.com, the world’s largest bond manager, Bill Gross of PIMCO, is shifting toward equities.

Global bonds guru Bill Gross, chief investment officer of Pimco, told CNBC Wednesday that he is making a shift towards equities.

“We are making a move into equities, period,” said Gross.

His rationale was somewhat surprising, but gives some insight into what he thinks of most sovereign credits these days:

“Corporate equities, in terms of valuation, are selling at very low P/E ratios and in some cases might be perceived to be almost as safe, or almost as secure as the sovereigns themselves,” said Gross.

When even the bond guys aren’t excited about owning bonds, you’ve got to scratch your head. Retail investors, on the other hand, are still piling money into bonds like crazy, I suspect in an effort to reduce their portfolio volatility. There might be more productive ways to accomplish the same task without taking on the risk of buying bonds at incredibly low yields. For example, a global allocation fund (like DWAFX or DWTFX) will typically have less volatility than most of the individual asset classes such as commodities or equities, but won’t necessarily lock you into a bond position. The volatility will clearly be higher than an all-bond portfolio, but the returns over time are likely to be higher as well.

For information about the Arrow DWA Tactical Fund (DWTFX) & Arrow DWA Balanced Fund (DWAFX), click here.

Click here and here for disclosures. Past performance is no guarantee of future returns.

Leave a Comment » | Investor Behavior, Markets, Tactical Asset Alloc | Permalink
Posted by Mike Moody

Volatility Is Not The Same Thing as Risk!

June 16, 2010

We repeat this to our investors often, so often I probably mumble it in my sleep. You can imagine, then, how excited I was to read this great article on risk and volatility by Christine Benz, the personal finance writer at Morningstar. The article makes so many outstanding points it’s hard to know where to start. I highly recommend that you read the whole thing more than once.

Ms. Benz starts with the “risk tolerance” section of the typical consulting group questionnaire. They generally ask at what level of loss an investor would become concerned and pull the plug. (In my experience, many clients are not very insightful; every advisor has seen at least one questionnaire of a self-reported aggressive investor with a 5% loss tolerance!) In truth, these questionnaires are next to worthless, and she points out why:

Unfortunately, many risk questionnaires aren’t all that productive. For starters, most investors are poor judges of their own risk tolerance, feeling more risk-resilient when the market is sailing along and becoming more risk-averse after periods of sustained market losses.

Moreover, such questionnaires send the incorrect message that it’s OK to inject your own emotion into the investment process, thereby upending what might have been a carefully laid investment plan.

But perhaps most important, focusing on an investor’s response to short-term losses inappropriately confuses risk and volatility. Understanding the difference between the two-and focusing on the former and not the latter-is a key way to make sure your reach your financial goals.

There are three different issues she addresses here, so let’s look at each of them in turn.

1) You’re a crummy judge of your own risk tolerance. We all are. That’s because our money is personal to us. One of my psychologist clients once exclaimed, “Money is my most neurotic asset!” It’s much easier to take an outside view and look at it with some psychological distance. An experienced advisor is more likely to be able to gauge your risk tolerance correctly than you are. There are also good resources like Finametrica for learning more about psychologically appropriate levels of portfolio risk. But Ms. Benz really gets to the heart of things: your risk tolerance will change depending on your emotions! That’s something no advisor can calibrate exactly, nor are you likely to guess how powerfully the swell of fear will hit you after a particularly heinous quarterly statement.

2) It’s not okay to panic. As Ms. Benz points out, discussing loss tolerance in this fashion implies that it is ok to bail out emotionally at some point. If you have losses that are uncomfortable, perhaps you need to revisit your overall plan, but it’s unlikely that major modifications are needed if you were thoughtful when you put it together in the first place. Markets, and strategies, go through tough periods and it’s important to be able to persevere.

3) At the height of emotion, volatility and risk get confused. Volatility is just a measurement of how much your investments are whipping around at the moment. Risk isn’t the same thing. Ms. Benz clarifies the difference:

…volatility usually refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period-a day, a month, a year. Such fluctuations are inevitable once you venture beyond certificates of deposit, money market funds, or your passbook savings account. If you’re not selling anytime soon, volatility isn’t a problem and can even be your friend, enabling you to buy more of a security when it’s at a low ebb.

The most intuitive definition of risk, by contrast, is the chance that you won’t be able to meet your financial goals and obligations or that you’ll have to recalibrate your goals because your investment kitty come up short.

Through that lens, risk should be the real worry for investors; volatility, not so much. A real risk? Having to move in with your kids because you don’t have enough money to live on your own. Volatility? Noise on the evening news, and maybe a frosty cocktail on the night the market drops 300 points.

This is one of the best descriptions of risk I’ve ever read, one that puts opportunity cost front and center. Risk isn’t your portfolio moving around; that’s just volatility—noise, really. Risk is eating Alpo in retirement, or as she mentions, being forced to move in with your kids.

Source: Purina

Risk is the very real possibility of having a severe investment shortfall if you avoid volatility like the plague. Low volatility investments earn low returns (or worse if they are Ponzi achemes).

The challenge of every individual investor, hopefully with help from a qualified financial advisor, is how to balance volatility and return-while keeping risk from sneaking up and biting you you-know-where. Ms. Benz has some thoughts on this as well:

So how can investors focus on risk while putting volatility in its place? The first step is to know that volatility is inevitable, and if you have a long enough time horizon, you’ll be able to harness it for your own benefit. Using a dollar-cost averaging program-buying shares at regular intervals, as in a 401(k) plan-can help ensure that you’re buying securities in a variety of market environments, whether it feels good or not.

Diversifying your portfolio among different asset classes and investment styles can also go a long way toward muting the volatility of an investment that’s volatile on a stand-alone basis. That can make your portfolio less volatile and easier to live with.

Again, she makes several very cogent points, so let’s deal with them one by one.

1) Volatility is inevitable. Deal with it. Preferably by constructing your portfolio thoughtfully in the first place.

2) Better yet, volatility can be your ally. Buy on dips. (Easy to say, harder to do.) In truth, high-return, high-volatility strategies can be tremendous wealth builders because the long-term returns are good and you get plenty of opportunities to add money during the dips. Toward that end, we publish a High RS Diffusion Index each week to help identify those dips in our particular strategy.

3) Diversify appropriately. We believe it’s often more fruitful to mix strategies as opposed to asset classes. For example, relative strength strategies tend to work very well when blended with deep value strategies.

Ms. Benz lays out the real definition of risk: failing to accomplish your goals.

It also helps to articulate your real risks: your financial goals and the possibility of falling short of them. For most of us, a comfortable retirement is a key goal; the corresponding risk is that we’ll come up short and not have enough money to live the lifestyle we’d like to live.

Clearly, the biggest risk for most investors is their own behavior. They avoid volatility rather than embracing it. Instead of buying on dips and being patient with proven strategies, they sell during pullbacks and buy only after an extended period of good performance. When you start to conceptualize risk as shortfall risk, you can also see that another of your big risks is not saving enough in the first place. At the risk of sounding like my mom, if you don’t have any money, no investment advisor is going to be able to help you retire. Savings, too, is behavior that can be modified.

What can be done to help clients embrace volatility, or at least deal constructively with it? Are there any ”nudges” that can be applied in order to increase their patience and their overall good investment behavior? Ms. Benz makes a suggestion in this regard:

Many financial advisors have begun to embrace the concept of creating separate “buckets” of a portfolio-and in particular, a bucket for any cash the investor expects to need within the next couple of years. By carving out a piece of your portfolio that’s sacrosanct and not subject to volatility or risk, you can more readily tolerate fluctuations in the long-term component of your portfolio.

Sure, it’s a cheap psychological trick that plays to the mind’s natural tendency to segment things-but if it helps, why not? We’ve discussed in the past that a portfolio carved into buckets is functionally equivalent to a balanced or diversified portfolio with the same asset allocation, but if it helps clients behave better then it’s worth trying.

Whether you are an advisor or an individual investor, educating yourself about key concepts like the difference between volatility and risk will pay large dividends down the road.

1 Comment | From the MM, Investor Behavior, Markets, Retirement/Saving, Thought Process | Permalink
Posted by Mike Moody

High RS Diffusion Index

June 16, 2010

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.) As of 6/15/10.

This indicator is reversing up after having reached very oversold levels. The 10-day moving average has now risen to 28% after having reached a low of 21% on 6/1. Dips in this indicator have often provided good opportunities to add to relative strength strategies.

1 Comment | Markets | Permalink
Posted by Andy Hyer