Pimco’s Gross Jumping Into Managed Futures

Warren Buffet is known for his quote, “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”

It has been cited so many times by so many people that you would think its underlying logic would be ingrained into the U.S. investors’ psyche but markets are irrational because people are irrational so no matter how many times someone has heard this piece of wisdom, there is a tendency to jump on investment bandwagons when the trend is long in the tooth and bail or stay out of underperforming investments right when they are ready to take off.

I am following one technician who thinks the stock market is close to topping but he is waiting for the last doubters to jump on the bull bandwagon before he puts out a sell signal.

Over the past few months I have been hearing a lot of pouting regarding managed futures. A lot of managers are having a hard time raising money because of poor recent performance and some are paring back their marketing efforts. The asset class suffered down years in 2011 and 2012 — the first back to back down years in the history of the Barclay CTA Index — and it is struggling midway through 2013 as well. The normal stories are being written, i.e. “Is Trend Following Dead,” and “What is wrong with Managed Futures.”

The correct answer may be, “I don’t know,” but anyone who understands the nature of the trend following beast also should understand that now is the ideal time to get in. Critics of the trend following approach like to point out that most investors don’t participate in the often strong returns of successful managers because of the tendency to get in after strong performance and get out after drawdowns.

First off I am not so sure the average investor is as dumb as some of these critics assume them to be. I have been examining money flows in CTA databases for more than a decade and noticed years ago that often money under management leaves following strong performance and returns following a drawdown.

Warren Buffett is not the only smart guy out there.

But the underlying logic of that criticism, and Buffett’s philosophy as well as the nature of trend following says that now is the time.

Why bring this up? Well another well-known investment guru, close to the stature of Buffett, has decided now is the time. Investment News reported earlier this week that massive bond investment firm Pimco, founded and managed by Bill Gross,  has filed a preliminary prospectus with the Securities and Exchange Commission (SEC) for a managed futures mutual fund named the Pimco Trends Managed Futures Fund.

The story points out the poor recent performance of managed futures but does note there have been some successes. It also points out that Pimco has made a point to add to its alternative portfolio since 2008, nearly quadrupling assets in alternative mutual funds, from $28 billion to more than $100 billion.

Has the market changed? Yes, markets always is change as Bill Eckhardt once told me. But remember so does managed futures. The beauty of it as an asset class is that it is not monolithic. There are literally hundreds of thousands of models looking to profit from trends in futures markets and while they may all end up in the same place when you have major trends, they get there in different ways. That is proven by the substantial number of managers that loosely fit in the trend following mode who have performed well over the recent difficult environment. These are not long only mutual funds but largely systematic strategies built to detect trends of varying time frames, in a mixture of up to 70 or so markets, with multiple risk management overlays. Yes there are better and worse environments for trend following and managed futures but these are truly absolute return vehicles that cannot really be benchmarked.

A perusal of CTA performance shows definite weakness in the last 30 months, roughly 60% of managers have a negative compound annual return since January 2011. But there are 51 managers with a compound annual return of greater than 10% in that time (out of a universe of 493). I have profiled 16 of them in the last few years.

Gross took a hit to his reputation back in 2011 by being a couple years early on his call for rising interest rates. I don’t think he is too early here and I feel a little better when I advise folks in the industry to make its push now for more assets. I am in good company.

Retiring Baby Boomers to Curb Bond-Yield Rise: Chart

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Baby Boomers’ influence on U.S. Treasuries will help hold yields down as people born in the initial decades after World War II shift to fixed-income assets to prepare for retirement, mirroring a pattern in Japan.
The CHART OF THE DAY shows Treasury yields have gradually declined as the proportion of U.S. citizens over 65 years climbed. The age group will swell to 20 percent of the population by 2030 from 14 percent now, according to the U.S. Census Bureau. The chart tracks a similar trend in Japan, where 24 percent are over 65 years, the world’s highest ratio of seniors, up from 19 percent a decade ago.
“As Japan’s population aged, that suppressed bond yields,” said Larry McDonald, the chief equity, credit and policy strategist at Newedge USA LLC in New York. About 4,100 Americans are turning 65 every day, quadruple the number in 2003, he told Bloomberg Radio’s “The Hays Advantage” earlier this month. “Those people are more likely to own bonds,” he said. Baby boomers are considered people born from 1946 to 1964.
Demand from retirees hasn’t been enough to offset a bond market rout this year. Treasuries have tumbled on speculation the Federal Reserve will taper an $85 billion monthly debt-buying program designed to stimulate the economy amid signs output and jobs are growing.Government securities have fallen 3.9 percent through Aug. 22, based on the Bloomberg U.S. Treasury Bond Index.
Japan’s 10-year bonds yielded 0.765 percent at the end of last week, the lowest of 27 developed markets Bloomberg tracks. The nation’s central bank has its own debt-buying program, worth about 7 trillion yen ($71 billion) of securities a month.
Investors are snapping up Japanese bonds even though the nation’s debt is equivalent to more than double its gross domestic product, McDonald said. The ratio is the highest in the world, data compiled by Bloomberg show. The U.S. debt is equivalent to 74 percent of GDP.

Dalio Patched All Weather’s Rate Risk as U.S. Bonds Fell

As the bond market plunged in late June, Ray Dalio convened the clients of Bridgewater Associates LP, the world’s largest hedge-fund manager, to tell them that a fund designed to withstand a broad range of market scenarios was too vulnerable to changes in interest rates.

Bridgewater, citing months of study, said it had underestimated the interest-rate sensitivity of various assets in its All Weather fund and was taking steps to mitigate the risk, according to clients who listened to or read a transcript of the June 24 call. By the end of the month, the Westport, Connecticut-based firm had sold off enough Treasuries and inflation-linked bonds to help reduce the fund’s most rate-sensitive assets by $37 billion, according to fund documents and data provided by investors.

The move, disclosed to investors five days after the Federal Reserve said it’s prepared to phase out its unprecedented bond purchases, was unusual for the fund. As its name suggests, All Weather is designed to produce returns in most economic environments and avoid altering asset allocations when the outlook changes. All Weather incurred a second-quarter loss of 8.4 percent that was primarily tied to its $56 billion portfolio of inflation-linked debt, said the clients, who asked not to be named because the fund is private.

‘A Foretaste’

The decline at All Weather and similar funds, including those run by Cliff Asness’s AQR Capital Management LLC and Invesco Ltd. (IVZ), shows Bridgewater’s pioneering strategy for allocating assets between stocks and bonds, known as risk parity, can leave investors overexposed to rising interest rates. The losses were amplified for some funds by a selloff in inflation-linked securities that also caught Bill Gross’s $262 billion Pimco Total Return Fund (PTTRX) off guard.

“This is just a foretaste of what is going to happen,” said Ramin Nakisa, a global asset-allocation strategist at UBS Investment Bank who co-wrote a March research report titled “When Risk Parity Goes Wrong.” Nakisa called June’s selloff in Treasuries and inflation-linked bonds “a dress rehearsal” for the volatility awaiting when the U.S. Federal Reserve actually begins to taper its bond-buying program, known as quantitative easing.

Bridgewater sold Treasuries and related futures contracts to reduce exposure to nominal interest rates and sold TIPS to address the extra exposure to inflation-adjusted, or real, rates, according to four All Weather clients.

Reducing Volatility

The sales were the result of longer-term research and not a reaction to the changing market outlook, said a person familiar with the firm. Most of the sales occurred before real rates began to rise in May and June, said the person, asking not to be named because the fund (AQRIX) is private. Without the sales, All Weather’s second-quarter loss would have been 1.5 percentage points higher, this person said.

Parag Shah, a Bridgewater spokesman, declined to comment.

The changes mark the first time that Bridgewater has made a substantive change to All Weather since the strategy’s inception in 1996, said the person familiar with the firm. The revision will reduce All Weather’s volatility by about 20 percent over a three-to-five-year time frame without affecting the fund’s ability to meet its goal of outperforming annual returns on cash by 5 to 7 percentage points, this person said.

Dalio Strategy

The firm had about $150 billion of net assets in two basic strategies as of early July. The $70 billion Pure Alpha fund is the flagship for making macroeconomic bets backed by extensive research. The passively run All Weather, which doesn’t make directional bets on or against markets, has grown faster in recent years, quadrupling to about $80 billion in assets since the end of 2009.

Originated by Dalio, 64, as a way to manage a family trust, Bridgewater spent decades developing All Weather into a formal strategy that seeks to balance the amount of risk that a portfolio derives from low-volatility assets such as bonds and commodities with that derived from more-volatile assets such as stocks. To do so, All Weather typically relies on leverage in the form of borrowed money or derivatives such as futures contracts to juice the potential returns from bonds.

The goal is to create a portfolio in which a quarter of the assets do well in each of four basic scenarios -- economic growth that is faster or slower than expected, and inflation that is lower or higher than forecast. While other investors might get surprised by inflation swings or a growth bust, “All Weather would chug along, providing attractive, relatively stable returns,” according to Bridgewater’s website.

‘Balanced Risk’

That has usually been the case, with All Weather posting average annual returns of 9.3 percent from its June 1996 inception through March, according to a May 13 Bridgewater client presentation. That compares with 7 percent gains for a benchmark portfolio with 60 percent in equities and the remainder in bonds, the traditional institutional model that, according to risk-parity proponents, derives almost all of its risk and potential returns from stocks.

“The whole concept of balanced risk is you don’t have the volatility in your system entirely driven by the equity market,” said Larry Swartz, chief investment officer at the Fairfax County Retirement Systems in Fairfax, Virginia, an All Weather investor that uses risk-parity concepts for its whole portfolio. Stocks “really depend on increasing expectations of growth.”

‘Chief Complaint’

Some traditional money managers such as Ben Inker, the director of asset allocation at Boston-based Grantham, Mayo, Van Otterloo & Co., have said risk parity owes much of its success to the tailwinds of a 30-year bond market rally, because the funds invest a large portion of their assets in debt and related instruments. Inker, in a March 2010 white paper, said the “beguiling combination of lower risk and higher return” that the strategy appears to offer is “largely an illusion.”

Excessive interest-rate risk has been “the chief complaint thrown at every risk-parity strategy for years and years,” said Thomas Lee, a senior portfolio manager at Clifton Group, a Minneapolis-based unit of Eaton Vance Corp. (EV) that provides clients with customized risk-parity products.

Robert Prince, Bridgewater’s co-chief investment officer, addressed such criticism in a Jan. 9 commentary, stating that rising interest rates generally stem from accelerating economic growth or increased inflation, environments in which All Weather’s bond losses would be offset by its profits on commodities and stocks.

‘Pretty Radical’

The exception to this scenario, Prince wrote, would be a small “subset of cases” such as an extreme tightening of liquidity caused by the Fed or an implosion of the financial system in which all asset prices decline. The impact of those cases would be short-lived, he said.

Equity and fixed-income markets both had bouts of selling in May and June when Fed Chairman Ben S. Bernanke signaled that the central bank might phase out its latest quantitative easing program, the monthly purchases of $85 billion of bonds. Bernanke rattled investors with comments suggesting that the Fed was prepared to taper its stimulus program even though inflation remained below targets previously set by the central bank before it would begin tightening.

Bernanke’s words were “pretty radical,” said John Brynjolfsson, the chief investment officer of Armored Wolf LLC, an Irvine, California-based money manager whose specialties include TIPS and commodities. “The implication is that he would be comfortable with inflation being below target rather than keeping his foot on the gas pedal until inflation exceeded the target.”

Gross’s Losses

The second-quarter losses fell particularly hard on funds that had loaded up on Treasury Inflation Protected Securities, or TIPS, which typically provide protection if interest rates are pushed higher by expectations for accelerating inflation. That wasn’t the case in May and June, as interest rates moved higher in anticipation of reduced asset purchases by the Fed, while inflation expectations receded, leaving TIPS among the biggest losers.

The $1.2 billion AQR Risk Parity Fund, managed by Cliff Asness’s AQR Capital Management LLC, fell 9.6 percent last quarter. Invesco’s $23.5 billion Balanced-Risk Allocation Strategy, which had avoided TIPS, declined 5.5 percent, according to a performance update obtained byBloomberg News.

The losses from the TIPS selloff also hurt some of the best-known traditional bond funds. Gross’s Pimco Total Return, the world’s largest mutual fund, declined 4.7 percent in May and June, also hurt by TIPS. Pacific Investment Management Co. in Newport Beach, California, which runs the fund, owned about 10 percent of the TIPS market, according to Morningstar Inc. (MORN)

Bridgewater’s Research

All Weather’s exposure to Treasuries and other nominal bonds equaled 48 percent of net assets and its exposure to inflation-indexed debt, including TIPS, was 70 percent, according to the May presentation. Because of leverage, asset-class exposures totaled 173 percent of net assets.

The fund benefited from its TIPS holdings since the Fed, in a bid to drive down long-term interest rates, began the first of three asset purchase programs in late 2008. The moves pushed inflation-adjusted interest rates below zero for a sustained period. All Weather’s annual returns averaged 16 percent from 2010 through 2012, well above the strategy’s target return of 5 to 7 percentage points above cash.

That prompted Bridgewater to begin doing research earlier this year on why the fund’s returns were higher than expected, a project that led the firm’s principals to conclude All Weather had too much exposure to “real” yields, said the person familiar with the fund.

TIPS Selloff

On the June 24 conference call, one day before the TIPS market fell to its lowest level in more than a year, Bridgewater said it hadn’t fully grasped the interest-rate sensitivity, or duration, for All Weather’s assets, according to people familiar with the discussion. As interest rates drop, stocks become more sensitive to the discount rate investors use to determine the present value of a company’s future cash streams.

Judging duration for equities is “messier” than it is for bonds, said Eric Sorensen, the chief executive officer of Boston-based PanAgora Asset Management Inc. That’s because a stock’s duration is also influenced by the type of company being examined and the reason rates are changing, said Sorensen, who co-wrote the 1989 article “A Total Differential Approach to Equity Duration” in the Financial Analysts Journal.

When inflationary pressures push rates up, bonds generally decline while stocks, particularly those of cyclical companies that can pass along price increases to customers, fare well, Sorensen said in an interview. This allows a risk-parity fund to offset fixed-income losses with equity gains.

Fed Easing

Stocks and bonds have both fallen in response to rising rates on several occasions during the past two decades, Sorensen said. When the Fed unexpectedly raised its target Fed Funds rate in early 1994, for example, the Barclays U.S. Aggregate Index declined 3.9 percent during the first half of the year and the Standard & Poor’s 500 Index fell 3.4 percent, with reinvested dividends.

This year, the S&P 500 fell more than 4 percent between mid-May and late June, when Bernanke made separate comments on tapering the Fed’s quantitative easing, while the yield on 10-year Treasury notes rose above 2.5 percent for the first time in 22 months. TIPS declined 7.4 percent during the second quarter, their worst showing ever, according to the Bank of America Merrill Lynch U.S. Inflation Linked Treasury Index.

‘Time to Hedge’

“The time to hedge that kind of risk is not when the risk is upon you,” said Sorensen, adding that he was speaking in general terms with no knowledge of Bridgewater’s situation. “If you had been hedging throughout for the potential of stocks and bonds to have a high correlation” to rate movements, he said, “you wouldn’t have made as much money.”

Bridgewater had increased the amount of TIPS across its strategies after the Fed began quantitative easing in late 2009, according to financial statements filed with the U.S. Department of Labor. TIPS held by the Pure Alpha and All Weather funds that file reports with the Department of Labor surged to $21.6 billion, or 31 percent of net assets, at the end of 2011 from $6.9 billion, or 16 percent, at the end of 2009. Bridgewater’s 401(k) plan had 16 percent of assets in the Vanguard Inflation-Protected Securities Fund at the end of 2011.

‘Popular Trade’

“The most popular trade of the last year has been on the back of quantitative easing, that it has to drive up inflation at some point,” Woody Jay, a principal at CRT Capital Group LLC, based in in Stamford, Connecticut, said in an interview. “The trade was so one-sided, it’s not surprising that TIPS were overdone in the selloff,” said Jay, a former chairman of the committee of securities dealers that advises the U.S. Treasury on debt issues.

All Weather trimmed its use of leverage to about 144 percent of net assets at the end of June, according to the clients who requested anonymity. Gross exposures to different asset classes declined to about $116 billion from $138 billion in the quarter, while net assets stayed at $80 billion.

The fund’s exposure to Treasuries and other sovereign debt declined to about $14 billion from $38 billion, and its gross holdings in inflation-linked debt decreased to about $43 billion from $56 billion, based on figures from the May presentation and the two investors who requested anonymity. These declines reflect changes in market value as well as sales.

Kotok:A Strategy Change

 It has been a busy two weeks. The Leen’s Lodge gathering added an intense interlude of high-powered conversation and analysis. The Yellen-Summers headlines now have two added mystery names per President Obama. The Fed (Federal Reserve) tapering talk adds the question “What is the policy?” to the question “Who will be making the policy?” Markets are going through gyrations in both bonds and stocks. And we see surprising reactions in foreign currencies, with the Japanese yen strengthening while changes in policy at the Bank of England have resulted in a market reaction opposite to what the BOE expected.

At Cumberland, there have been a number of strategy changes. Clients are aware of these changes by observing the activity in their accounts. We will summarize here the strategy changes and the reasons for them. Expect further commentaries on these matters as we keep you apprised of factors affecting the market and our timely responses to changing conditions.

We have raised cash in both US and international equity accounts. The bottom line is that the risk profile in stock markets is up. There are questions about the pace of economic recovery, some of the sectors such as energy or housing, and the impact of the Fed’s talk of tapering and what it is doing to risk premia and re-pricing in the market. The possibility of a Summers Fed chairmanship, coupled with Elizabeth Duke’s departing, Jerome Powell’s term ending next year, Sarah Bloom Raskin’s leaving for the Treasury, and Janet Yellen’s departing (If she is not appointed chair?) , leads market agents to conclude that an entirely different configuration of the Fed board may soon be at hand.

Add to that the retirements of some of the seasoned presidents (Cleveland Fed president Sandra Pianalto has announced), and the structure of the US central bank may reach a point where the remaining experienced and historically seasoned members of the FOMC (Federal Open Market Committee) are few. New observers and appointees may have seen the financial crisis from the outside; however, they will not have acquired firsthand the knowledge and experience gained only through making decisions under fire. Markets are aware that they face the biggest US central bank transition in many years.

Bond markets have backed up in yields. This is true in the Treasury, municipal and taxable bond markets. We have written about how yields have been distorted and yield spreads have widened enormously. Our example was a trading day in which the 30-year US Treasury obligation (federally taxable) traded at 3.62% yield. In the same 24-hour period, the tax-free New Jersey Turnpike traded at 4.73% yield, and the taxable New Jersey Turnpike traded at 5.15%. In our view, the tax-free turnpike bonds are screaming bargains in the present climate. In fact, Cumberland owns them in clients’ accounts.

Risk management issues loom larger than usual. What do you do when the stock market has reached your next year’s target? Our target was the S&P 500 at 1700 by the end of 2014. We are there. What do you do when the outlook for earnings is starting to deteriorate? We have ratcheted back our S&P 500 estimates for this year by a couple of dollars. We still think that earnings will come in around $110, give or take $2. The picture is trending toward more softness in earnings growth.

What do you do when the outlook for the future earnings growth rate is also deteriorating? We base that assessment on the fact that the profit share of the GDP in the US is at the highest level it has seen in decades and the labor share is at the lowest level. That means productivity seems high and earnings that come from that profit share seem to be strong. Could the profit share go higher? Yes it could. Is that likely now? We think not. Furthermore, the ratio of the value of the entire S&P 500 index to the GDP has reached 100%. History (Ned Davis database) suggests that this is a dangerous level.

We think the profit share of the GDP is rolling over, peaking, and tipping into what might be a long-term decline from this very high level. And the labor share may be bottoming and is positioned now to start a gradual rise over time from this very low level. If this view is correct, then American companies begin to face headwinds that will slow the earnings growth rate. This is not just a day-to-day, week-to-week or month-to-month rate of change. This is strategic. What lies before us is a longer-term stretch in which the tremendous benefit to American business from central bank policy in the post-crisis period will come to an end.

Lastly, there is the issue of demographic headwinds. Rob Arnott, a guest at Leen’s Lodge this year, has offered thoughtful analysis on demographics. He notes, in his serious research, how strongly demographics have contributed, in the past, to accelerating growth rates, and he forecasts significant headwinds that demographic change may introduce into our strategic future.

Put that package together and there emerges a set of circumstances in which stocks, having risen terrifically, now look less appealing at the current price level. Certain sectors of the bond market, by contrast, look more appealing.

Consider that New Jersey Turnpike 4.73% tax-free yield. We sat in a meeting with one of our New Jersey clients and reviewed his portfolio. The client is a successful businessman. He was joined in the meeting by his financial professional. We dissected his New Jersey tax bracket. He is somewhere in the 51%-52% marginal tax bracket. He is a New Jersey resident paying federal income taxes and New Jersey taxes at the top rates. He bumps up against levels which limit his deductions and expenses when he completes his tax return. And we must add the Obamacare tax he pays. That is how his marginal tax rates reach 52%.

Sitting in that meeting, we took apart 4.73% as a yield that he can obtain by investing in a long-term debt instrument with a senior claim on the revenues of the New Jersey Turnpike. The compounding taxable equivalent yield for him is approximately 9.5%. He can get that yield year after year.

What that means is that, to scrape up a viable and comparable investment alternative, he would have to find an investment somewhere else deriving a taxable income of 9.5% and pay all of his taxes on that percentage. The residual would equal the return generated by the New Jersey Turnpike instrument. Where are you going to find such a low credit risk, high quality, and liquid investment in New Jersey to compound at a 9% or 9.5% rate pretax so that you can derive a match against the New Jersey Turnpike? I cannot see any, and neither can he. That is why we allocated in favor of his tax-free bond portfolio. Do the same math with some long-term holding and use the 20% capital gains rate. Add Obamacare tax and add NJ taxes. The case for the New Jersey Turnpike tax-free bond is still very compelling.

We have changed our internal asset-allocation mix at Cumberland Advisors. In the beginning of this cycle, we were as high as 80% stocks in balanced accounts. That allocation has been reduced to 60%. We have taken the bond piece up to 40%. Furthermore, we have extended duration in individually managed accounts. The entire hubbub over Detroit, San Bernardino, and other specific tax-free municipal bond credit issues has provided an entry opportunity in the tax-free municipal bond market that is unparalleled except for one other time. I would characterize that other time as the “Whitney moment,” when Meredith Whitney went on 60 Minutes and predicted the end of the municipal bond world. Let’s call this current time the Whitney-esque moment.

We are buyers of tax-free bonds. We have a cash reserve in our US equity and international ETF accounts. That cash reserve is higher than it has been in our accounts in quite some time. And we are going to hold that cash reserve on the sidelines for a time. We cannot say how long and we do not know when or how much will be redeployed.

We are now facing the transitional period for the central bank. We do not know who the next chairman is going to be or what the composition of the board will be. But we do know that the current wave of uncertainty will soon be cresting into decisions sure to have cascading consequences in churning markets. We have seen a lineup of commentary coming from FOMC members that suggests a form of tapering is coming.

We are not afraid of tapering. Tapering by itself is not an issue if it is coupled with an extension of the short-term interest-rate commitment. In other words, the Fed can cut the rate of additional purchases and use guidance to extend the period before and until the Fed Funds rate will be elevated from its present 0.0%-0.25% range. Some members of the FOMC are thinking that tapering means reducing the amount of stimulus but extending the time period in which it is applied. If the market grasps that concept, bonds will rally, and tax-free bonds even more so.

Think about it. If the inflation rate in the US is roughly 1% and there is a possible downward trend, then a 4.73% tax-free New Jersey bond is delivering a real return of 3.73% after taxes to a New Jersey resident. That is a phenomenally high return on an investment for someone living in New Jersey. The real return is still quite high if the inflation rate heads up to 2%. This is now a win-win for an individual investor. There are similar opportunities in jurisdictions throughout the US.

To sum this up, carefully selected bonds now offer an entry opportunity and long duration. It is critical to check the quality of credits, particularly in the municipal bond market.

Stocks require selectivity as to sector activity and many other characteristics. We have had terrific success in our US ETF portfolios this year. We do not want to give those strategically achieved profits back. So we now have a cash reserve until we get through this difficult period.

~~~

David R. Kotok,
Chairman and Chief Investment Officer, Cumberland Advisors

ETFs Spur Loan Volatility as Funds Attract Cash: Credit Markets

Leveraged loans are becoming more volatile as they attract unprecedented cash from investors seeking debt that offers protection from rising interest rates.

Loan prices have swung 11.92 cents on the dollar since the end of 2010, compared with a 1.5-cent fluctuation in the three years ended Dec. 31, 2006, according to the Standard & Poor’s/LSTA Leveraged Loan 100 index. Mutual and exchange-traded funds that focus on the floating-rate debt have attracted about $45.5 billion of new money this year, increasing their assets by 60 percent, according to Bank of America Corp.

While the flows have helped speculative-grade companies refinance and lower rates on more than $300 billion of existing loans, concern is rising that the cash could flow out just as quickly, causing borrowing costs to soar. Mutual funds and ETFs now own about 20 percent of the U.S. leveraged-loan market, about the most ever, and may contribute to bigger price swings going forward, according to Fitch Ratings.

“I don’t think it’s all going to be smooth sailing,” Darin Schmalz, a director at Fitch in Chicago, said in a telephone interview. “Looking at loans over time, it was a pretty stable asset class. We found out this can be a volatile asset class.”

Bond Outflows

This year’s flows into leveraged-loan funds contrast with $9.3 billion of withdrawals from U.S. high-yield bond funds, JPMorgan Chase & Co. data show, with investors fleeing debt that’s grown more vulnerable to rising rates after a four-year rally pushed yields to record lows. Yields on 10-year Treasuries climbed to 2.83 percent Aug. 16, the highest since July 2011 as the Federal Reserve considers slowing its unprecedented stimulus effort.

Trading has increased more than 12 times this year in the biggest leveraged-loan ETF, Invesco Ltd.’s PowerShares Senior Loan (BKLN) Fund, as investors seek a quick and easy way into a less-liquid, over-the-counter market, according to data compiled by Bloomberg.

Volumes in the underlying debt aren’t rising as quickly, increasing 53 percent in the past year, according to the Loan Syndication and Trading Association.

ETFs “might be a small part of the market, but they can have an outsized impact on market prices relative to their size,” Eric Gross, a credit strategist at Barclays Plc in New York, said in a telephone interview. “Investors and traders need to be cognizant of what the ETFs are doing because they can affect pricing, sentiment, and flows.”

Bond Yields

Elsewhere in credit markets, the cost to protect against losses on corporate bonds in the U.S. rose with the Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, rising 1.3 basis points to a mid-price of 82.8 basis points at 11:55 a.m. in New York, according to prices compiled by Bloomberg.

In London the Markit iTraxx Europe Index of credit-default swaps tied to the debt of 125 companies with investment-grade ratings rose 0.23 to 99.05.

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of debt.

Swap Spreads

The two-year U.S. swap spread was unchanged at 18.9 basis points. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

Bonds of Charlotte, North Carolina-based Bank of America were the most actively traded dollar-denominated corporate securities by dealers last week, accounting for 3.52 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Investors have gravitated toward leveraged loans as they seek protection from losses incurred by rising rates while also getting extra income from lower-rated securities. Yields on 10-year Treasuries (USGG10YR) rose by more than a percentage point since December as Fed Chairman Ben S. Bernanke indicated policy makers could scale back monthly bond purchases this year.

Policy ‘Misunderstanding’

Loans are typically pegged to floating-rate benchmarks that rise alongside increasing benchmark borrowing rates.

“It’s easy to raise money by offering such a simple solution,” Gary Herbert, a fund manager at Brandywine Global Investment Management LLC, which oversees about $38 billion in fixed-income assets, said in a telephone interview. “Smaller companies that are aggressively levered dominate the loan market. There’s a lot of misunderstanding about what happens when the central bank’s balance sheet shrinks.”

Loan mutual funds now manage more than $115 billion in assets, up from $71 billion in 2012, JPMorgan said in an Aug. 8 research note. Two new leveraged-loan ETFs started trading this year, including the SPDR Blackstone/ GSO Senior Loan ETF (SRLN), a joint venture betweenBlackstone Group LP (BX) and State Street Corp. The fund started with $65 million in assets and has multiplied more than seven times in the last four months to about $475 million.

Invesco ETF

Invesco’s PowerShares Senior Loan fund, the first and biggest loan ETF, has grown to about $5 billion in assets since its inception in March 2011. The $5.5 billion in assets under management for loan ETFs at the end of July accounts for about 1 percent of borrowings included in the S&P/LSTA index, according to an Aug. 12 report from CreditSights Inc.

Trading volumes in Invesco’s ETF rose to an average 3 million shares per day in July, from about 241,000 a year earlier, Bloomberg data show.

“The market is still being driven by CLOs, but the relative importance of mutual funds has grown, and ETFs are kind of a tail on that dog at this point,” Alex Jackson, the head of the bank loan group in Armonk, New York at Cutwater Asset Management, said in a telephone interview. “The price volatility of the loan market is almost double what it was pre-crisis.”

Loan Prices

The average price on the 100 largest first-lien loans climbed to a six-year high of 98.88 cents in May from 96.1 cents at the end of December, according to the S&P/LSTA U.S. Leveraged Loan 100 index. Accelerating demand for floating-rate debt has enabled speculative-grade borrowers to refinance $157 billion of loans this year, while reducing the rate on $187.7 billion of existing loans through the end of July, according to S&P’s Capital IQ Leveraged Commentary and Data.

This year’s rally has reversed the eight-month stretch through October 2011, when loan prices fell 9.5 cents as concern grew that policy makers would be unable to reign in spiraling borrowing costs in Europe that hampered Ireland and Portugal’s ability to sell debt. Spain, Greece, Ireland, Portugal and Cyprus all required bailouts, with policy makers creating the European Financial Stability Facility in 2010.

During the financial crisis, in the fourth quarter of 2008, bank loans underperformed speculative-grade notes, losing 23 percent.

‘Post-crisis’ Market

“The interesting thing to note though is how the loan market has evolved post-crisis,” Fitch’s Schmalz said. The growth in the proportion of the market owned by individual buyers “will have an impact if investors begin to take money out of the asset class, which will force retail funds and ETFs to sell,” Schmalz said.

While collateralized loan obligations are still the dominant owners of the $593 billion U.S. leveraged loan market, holding about 53 percent of the debt, their share has dropped from 60 percent in the first quarter, according to the LSTA.

The volume of loans traded in the secondary market jumped to $150 billion in the three months through June, compared with $98 billion in the same period last year, LSTA data show.

The floating-rate debt has gained 3.1 percent this year, according the S&P/LSTA Leveraged Loan Index, outpacing the 2.3 percent gains on the Bloomberg USD High Yield Corporate Bond Index.

“There’s been a blindness toward the concept of risk while choosing duration protection,” Herbert said. “When the market sentiment turns, the less sophisticated investors will be the ones harmed.”

Tapering plan drives investors into riskier debt

The Federal Reserve’s plan to end quantitative easing, in part to prevent financial bubbles, is in fact driving investors into riskier corners of the debt markets.

While the safest bonds have sold off hardest since Ben Bernanke, Fed chairman, set a timetable for tapering its monetary stimulus, the best-performing fixed-income assets have been the lowest-rated junk bonds.

Junk bonds rated triple-C, the lowest tier possible, are the only corporate bonds to have generated positive returns since Mr Bernanke’s June 19 press conference, when he said the Fed would most likely start scaling down its Treasury and mortgage purchases this year and wind them up by the middle of next.Money has also poured into loans in the past three months, with the result that many borrowers no longer have to provide customary investor protections.

“Investors are so afraid of rising rates that they are trading off rates risk by taking on more credit risk,” said Ashish Shah, head of global credit at asset management group AllianceBernstein.

Riskier bonds tend to offer higher interest rates and so repay their purchase price more quickly – a measure called “duration” – something that has become critically important in a rising interest rate environment. Longer duration bonds fall more sharply when market interest rates rise.

Investment grade bonds have lost 1.3 per cent and double-B rated junk bonds have shed 0.8 per cent since June 19, compared to a positive return of 0.9 per cent for the triple-C class.

The extra yield, or spread, that triple-C investors are demanding over risk-free Treasuries has narrowed by 20 basis points over the same period, compared to 5 basis points for investment grade corporate bonds.

Bankers have been emboldened by the demand for high-yielding investments to seek more advantageous terms for borrowers.

Matt Duch, a portfolio manager at Calvert Investments, said there had been an increase in borrowers seeking to add high leverage and “payment-in-kind toggle” deals, which give borrowers the option to pay lenders with more debt rather than cash.

“The strong demand for low-rated high yield could be fostering a generation of paper with subpar structures,” he said. “That could definitely be a problem in the future should defaults pick up or financing suddenly become less available.”

Some of the most aggressive deal structures are being proposed in the loan market, which is used for financing leveraged buyouts. There have now been 61 consecutive weeks of inflows into mutual funds and exchange-traded funds specialising in loans, according to Lipper, adding up to $39.1bn of new money chasing investment opportunities. Some $11.6bn has been added since June 19.

Because loans offer a floating rate of interest, they are seen by investors as insulated from the risks of rising rates as the Fed tapers QE.

The US software group BMC, which was acquired by a private equity consortium led by Bain Capital and Golden Gate Capital, this month sold $5.86bn of debt with only light covenant protections for investors and with an unusual provision giving more freedom to sell assets before repaying lenders.

The use of “covenant-lite” loans has re-accelerated since Mr Bernanke’s remarks, accounting for 58 per cent of all loan issuance so far this month. That puts August on course to be the second highest month ever, after January 2013, according to S&P Capital IQ.

Warren Buffett, age 44, explains the futility of playing the market

Warren Buffett, at an even younger age, in 1962. KMTV

In 1975, shortly after joining the board of the Washington Post Company, Warren Buffett wrote a letter to the chairman and chief executive, Katherine Graham. He had some advice as to how the company should invest its pension accounts.

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All 19 pages were recently published by Fortune, and are well worth reading. In the brief excerpt below, Buffett, then just 44 years old, makes a succinct case against traditional stock picking and fund management. We’ve highlighted some passages, and you can annotate the text by hovering over any paragraph and clicking the quote bubble off to the right.

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If above-average performance is to be their yardstick, the vast majority of investment managers must fail. Will a few succeed due either to chance or skill? Of course. For some intermediate period of years a few are bound to look better than average due to chance just as would be the case if l,000 “coin managers” engaged in a coin-flipping contest. There would be some “winners” over a 5 or 10-flip measurement cycle. (After five flips, you would expect to have 31 with uniformly “successful” records—who, with their oracular abilities confirmed in the crucible of the marketplace, would author pedantic essays on subjects such as pensions.)

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In addition to the ones benefitting from short-term luck, I believe it possible that a few will succeed—in a modest way—because of skill. I do not believe they can be identified solely by a study of their past record. They may be operating with a coin that they know favors heads, and be calling heads each time, but their bare statistical record will not be distinguishable from the larger group who have been calling flips indiscriminately and have been lucky—so far.

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It may be possible, if you know a good deal about investments as well as human personality, to talk with a manager who has a decent record and find that he is using methods which really give an advantage over other investors, and which appear to be likely to provide continued superiority in the future. This requires a very wise and informed client—and even then is not free from pitfalls.

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For openers, there is one huge, obvious pitfall. I am virtually certain that above-average performance cannot be maintained with large sums of managed money. It is nice to think that $20 billion managed under one roof will produce financial resources which can hire some of the world’s most effective investment talent. After all, doesn’t the big money at Las Vegas attract the most effective entertainers to its stages? Surely $50 million annually of fees on $20 billion of managed assets will allow an array of industry specialists covering minute-by-minute developments affecting companies within their purview; top-flight economists to study the movement of the tides; and nimble, decisive portfolio managers to translate this wealth of information into appropriate market action.

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It just doesn’t work that way.

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Down the street there is another $20 billion getting the same input. Each such organization has its own group of bridge experts cooperating on identical hands and they all have read the same book and consulted the same computers. Furthermore, you just don’t move $20 billion or any significant fraction around easily or inexpensively—particularly not when all eyes tend to be focused on the same current investment problems and opportunities. An increase in funds managed dramatically reduces the number of investment opportunities, since only companies of very large size can be of any real use in filling portfolios. More money means fewer choices—and the restriction of those choices to exactly the same bill of fare offered to others with ravenous financial appetites.

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In short, the rational expectation of assuring above average pension fund management is very close to nil.

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The entire memo can be read at Fortune. The 1962 image of Buffett is from an interview with an Omaha, Nebraska, television station, KMTV.

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Diversification Isn’t Broken, It Just Takes a While

It’s a classic moment in sports history. With less than 20 seconds left in Game 6 of the 1998 N.B.A. finals and the Chicago Bulls down by one, Michael Jordan goes one-on-one with Bryon Russell of the Utah Jazz. He pushes off (clearly!), Russell stumbles and the ball hits nothing but net. Game over. Bulls win.

Now let’s imagine that something different happened. Jordan misses the shot in Game 6, and Game 7 comes down to the same spot: fewer than 20 seconds left with the Bulls down by one. If you’re Phil Jackson, the head coach, do you set up the last play for Jordan, or does the ball go to someone else? Remember, Jordan missed the night before.

Of course the right strategy is to put the ball in Jordan’s hands. Just because he missed the shot before doesn’t mean it was the wrong strategy to have Jordan shooting the ball in the final seconds. The odds are incredibly high that he will make the shot even though he missed it the night before.

I bring this up because it perfectly captures the investing adage that never seems to die: diversification is “broken.” It seems as if this story pops up every year, but it’s not really about anything new. Both Joshua M. Brown at The Reformed Broker and Barry Ritholtz at The Big Picture have written blog posts about it recently. Mr. Brown quoted an adviser who said:

“Why bother diversifying at all? It’s just a drag on performance. What’s the point of owning any bonds or international stocks?”

So here’s the 2013 version of the diversification story.

Let’s say at the beginning of 2013 you finally decided you were going to stop pretending to be a trader and instead be a long-term investor. You were going to do what most of the academic research recommends and build a diversified portfolio of low-cost investments. Then you planned to hold on to it for a long time.

As part of your new plan, you put something like 30 percent of your portfolio in international mutual funds. Now seven months into the year, you’re disappointed because international has done poorly relative to your Standard & Poor's 500-stock index fund. In fact, year to date, your S.& P. 500 index fund is clearly the only place you should have put all your money. Its gains have been twice those of almost any other major asset class.

Obviously, it was a mistake to diversify, right? Wait. Before you answer, let me share one of my favorite stories about diversification.

In 1998, the S.& P. 500 ended the year up 28.6 percent. But nothing else was really performing. Small-capitalization stocks were down 2.2 percent, and small-cap value stocks were in the tank. The temptation to go all in on large-cap technology stocks proved to be too much for most of us. After all, nothing else was working.

Now fast forward to 2001. The tech bubble had burst. The S.& P. 500 was down a bunch in 2000 and ended 2001 down 11.9 percent. Based on those numbers, it’s fair to assume the stock market was terrible, right? Well, it depends on which market you were talking about.

Remember those small-cap stocks that everyone was complaining about in 1998 and ’99? Sit down for this. In 2001, while the S.& P. 500 was getting crushed, small-cap stocks returned 17.6 percent. And small-cap value stocks, down 10 percent in 1998, ended 2001 up 40.6 percent.

Wild!

I suspect your first thought to this example is, “Why not just buy things right before they go up and sell before they go down?” Let me save you a lot of money and many headaches. It’s all but impossible for investors to catch all the up while avoiding all the down. But it can be equally difficult for us mere mortals to stick with diversification because it looks as if we should be able to time the market, and, well, diversification isn’t sexy or exciting.

First, diversification works over time, and no, seven months doesn’t count. When we talk about diversification working, we’re talking in terms of years, even decades. Not just days, weeks or even months. In other words, we’re talking in investing terms, not trading terms. We don’t like things that take a long time to work. We want to know what’s working now.

Second, diversification is not exciting. It’s the investing equivalent of hitting singles and doubles your whole life, and who grows up wanting to do that? We want to hit home runs. Players who try to hit home runs every time (like timing the market) are going down swinging in a blaze of glory or knocking it out of the park. Either way, it’s cool, sexy and exciting — all the things diversification is not.

Finally, diversification can look like a mistake at any given moment. A well-designed and diversified portfolio will always have something that’s not doing well, a few things that are average, and, hopefully, one or two things that are exciting. The problem, of course, is that the investments change places about the time you’ve had enough and you decide it’s time to boot out the underperformers. It’s human nature to run from things that cause us pain and get more of the things that bring us pleasure. It’s why we look for ways to “fix” our portfolios.

It may seem counterintuitive, but if you have something in your portfolio that you’re complaining about, it’s a good sign you’ve built a diversified portfolio. And if that’s the case, you’re probably complaining right now about international mutual funds and wondering why you aren’t invested 100 percent in the S.& P. 500. But as Mr. Brown so wisely notes, “Five months still to go, anything can happen …”

Next year, there will be a different story about why diversification is “broken,” but all it takes is looking at the year before that, then 5, 10, 15 and 20 years before that to see why you want to hit singles and doubles for the rest of your investing life. Personally, I’d rather save my energy for other things besides trying to second-guess which market will take off next. I’ve got better things to do. Don’t you
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