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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After Taxes, Aaa Muni Yields Close in on Baa Corporates

In the wake of the concerns stemming from Detroit’s bankruptcy filing, yields on municipal bonds have soared–even those with impeccable credit quality. In fact, according to Anthony Valeri, Fixed Income Strategist for LPL Financial, the taxable-equivalent yield on 10-year, triple-A-rated municipals has nearly matched that of Baa corporate bonds.

“The near-similar yields, after accounting for the impact of taxes, show that current municipal bond pricing is depressed to the point that investors are disregarding credit quality differences. The last time the [taxable equivalent yields] of high-quality municipals and middle-tier rated corporate bonds converged was in late 2010 and early 2011, following dire prognostications on the market from Meredith Whitney that induced a sell-off,” he writes.

What’s more, the default rate on medium-grade Baa municipals since 1970 has been lower than that of top-tier Aaa corporates, Valeri also points out, 0.16% versus 0.50%. To be sure, state and local governments face far greater challenges than in the past four decades, notably unfunded pension liabilities. None of which is new news, however.

With the relative pricing of tax-exempt munis out of whack with taxable counterparts, crossover buyers have emerged to take advantage of munis’ cheapness, he adds. That should help to spur an improvement in relative performance of the municipal market.

“We continue to believe current municipal valuations provide an opportunity for patient bond investors and an attractive alternative to corporate bonds with the added benefit their tax exempt status kicked in for no additional cost,” Valeri concludes.

Ben Inker Q&A: High Profits, High Quality, and China Bubbles

Kinnel: I'm intrigued by a line in your latest commentary hot off the presses in which you said, "There is no asset class that you can hold that would be expected to do well if the real discount rate rises from here." So, what does that mean we should do--just hold cash?

Ben Inker: No, it definitely doesn't mean we should only hold cash, because all asset classes are to one degree or another trading higher than their historic averages. You can make a case that maybe European value and emerging-markets equities aren't, but if you adjust for things it's not even clear that they are cheap relative to historic averages. The reason everything looks that way is we have very low current discount rates, very low cash rates, and very low expectations of future cash rates.

So, you are getting paid for taking a risk of owning something other than cash. The trouble is if those cash rates normalize, then everything whose price was pushed up by the very low cash rates would be expected to get hurt. And if that happens, and it's not guaranteed to happen, you get events like we saw in late May and June, where asset classes all around the world that normally seem unrelated to each other get hit simultaneously.

That is a risk that exists today in the markets because of the very, very low discount rate. That makes everything somewhat riskier, but it doesn't mean you want to sit there and hold cash unless you know rates are going to rise soon because sitting in cash you are earning nothing and in the meantime sitting in other assets you're earning something. So the better an idea you have of when cash rates are going to normalize, the easier it is to figure out what portfolio you should have.

Kinnel: So you're saying it makes sense to be cautious, but don't flee the market?

Inker: So we are running more cautiously than normal, but not hugely so. We're not in a situation we were in say in 2007, 2008 when we were trying to figure out exactly how little the clients would let us get away with having risky assets and going there because in 2007, 2008 you weren't getting paid for taking risks. So, if you're not getting paid for taking risk, you might as well not take it.

Today you're getting paid for taking risk. But, we worry about what happens if cash rates go back to normal. Normally, you don't have to worry about that because normally cash rates are normal.

Kinnel: I think an interesting feature of your forecast is you've had U.S. high quality with a modest but decent return, and then the rest of U.S. equities with a negative seven-year forecast. Would you explain how that might happen?

Inker: Sure. We quite like the quality stocks relative to the rest of the U.S. market for two basic reasons. One of them is for one of the very few times in history you can buy these guys at a discount to the overall market. So they are trading at a lower P/E than the broad market. Normally they trade at somewhere between a 10% and 20% premium. So, that's pretty cool. You get to buy high-quality stocks at a discount.

The other reason we think they are particularly appealing versus the rest of the U.S. market right now is the biggest reason why we dislike the U.S. market: It is not its current P/E, but the fact that the earnings that make up that current P/E are at all-time highs and, from a profit margin perspective, we think are quite stretched. So we think profit margins are likely to be coming down over the next three to five to 10 years in the U.S., and under those circumstances, the quality stocks have this nice feature that their profitability is much less volatile than that of the rest of the market.

So, a narrowing of general profit margins doesn't leave these guys unscathed. In a recession,  Coca-Cola (KO) and  Johnson & Johnson (JNJ) and the rest of them all face more trouble than when times are really good, but the big, stable, high-quality stocks are less at risk if general profit margins fall, at least under our analysis, and that means you're getting two benefits. You're getting less expected fall as profit margins narrow and you're getting less fall as P/Es decrease. Because we think even these guys have slightly too high a P/E and slightly too high a profit margin, which is why we're saying 3.7 real instead of 5.5 to 6 real, which we think is normal for equities.

Kinnel: Can you give us a brief explanation of how you define quality or high-quality?

Inker: For us a high-quality stock is the stock of a company that has high profitability across the economic cycle, stable profitability, and low debt.

Kinnel: In April, you wrote about how corporate profits have been very high for a long time, leading you to wonder why reversion to the mean hasn't hit yet. What's your current thinking on this?

Inker: The behavior of corporate profits in the U.S. for the last 10 or 15 years is weird. It doesn't follow a standard capitalist script. If you've got a situation where there is a very high return on capital, which there has been on average for the last 10 or 15 years, you would expect to get a lot of investments. If the return on investment is high, capitalists go out there and invest. [If] the return on investment is low, they don't.

Well, the return on investment has been high, and yet we have been investing really quite little. There was a burst associated with the Internet bubble, but since then investment has been somewhere between a little bit anemic and, today, downright depressing. That doesn't do anything for expectations of future growth, because productivity growth really does require investment and we're not getting much investment. So, it's hard to see how we're going to get productivity growth, but profits for companies are really less about productivity growth and more about the return on capital. And if you are not getting a lot of investment, then you don't get one of the avenues towards pushing profit margins back down. Normally, higher investment would happen and that would lead to higher competition and the erosion of profit margins. So, if we're looking for reversion in profit margins, which we are, it's sort of the longer-term more subtle issues about what does it mean to have high profits in the corporate sector that is not accompanied by high investment.

When that doesn't happen, the economy can face inadequate demand. So, the corporations--if they truly are just sitting on cash--you have a problem, because nobody is spending that cash. If they do spend that cash by paying out dividends or buying back stock, the problem is that it disproportionately goes to rich people--and rich people, by and large, have a lower propensity to spend income than the rest of households.

So, even if they pay it out, it's just not clear where the demand is going to come from in the economy, and for a while that was buoyed up by spending associated with the housing boom, barring a move back into those unsustainable housing bubble condition. It's not clear how that happens. So, our best guess is that profit margins will be under pressure for the next five or 10 years, just because of the unsustainability of supporting demand without sufficient household income growth. You can see it in the resource sector where lots of people have spent a lot of money, building new iron ore plants and new capacity to get iron ore to market, that creates additional supply. And at the same level of demand, you would expect prices to fall. That's the nice straightforward microeconomic issue. What we think is going to be happening to profits is kind of more of a macroeconomic issue.

Kinnel: Emerging markets are the brightest spot of your forecasts with a 7% real return forecast, which is interesting given that this year a lot of the news has been about a slowdown in China.

Inker: Well, we have not actually been acting as if we believed that 7% forecast. That 7% forecast is assuming everything goes back to normal, and one of the things we've been concerned about and that we have written about is the problem of China. And my colleague Edward Chancellor has been writing about it for a couple of years--that, as we see it, China has a fixed-asset investment bubble and a credit bubble and a real estate bubble. [That's] not the same thing as having a stock market bubble, but it has significant implications for not just the Chinese stock market, but for all of emerging markets. As a result, we have been more cautious on emerging markets than our forecast would suggest, and we still are.

Emerging markets have some real problems, and we are trying to figure out exactly how they will play out. We still think you've got to own some, because they are pretty cheap even if they do have some problems. And certainly having underperformed the U.S. by 27%, 28% so far this year, they are getting more attractive. I'm not sure they are quite as attractive as the forecast, which is assuming we get to go back to normal, when it isn't entirely clear what normal is for these economies.

Kinnel: And, of course, these are return forecasts, not risk return forecasts.

Inker: Yes, but we are not just saying that. We could say it's going to be 7%, but it's going to be a bumpy ride, so hold on. We're perfectly happy to hold assets where we think the ride is going to be bumpy. The biggest concern we have is effectively that 7% return is assuming that more or less all of the very strong growth emerging markets have had for the last decade was secular growth. If some portion of it was instead this cyclic goal issue of selling into a bubble in China and when that bubble bursts, the sustainable level of sales and earnings and assets will all be lower, then it's not just that you get a bumpy ride, but you're not going to get the 7%. And that's what worries us more.

We're perfectly happy to take a volatile 7%, and again we do own emerging markets and may well start buying some more over the next couple of months, but the big concern is we don't quite believe it's as cheap as our standard analysis makes it look.

Kinnel: You're still forecasting negative real return for bonds even though rates have backed up a little. I gather bonds are still not attractive to you.

Inker: Not particularly attractive. We have started to buy some TIPS, and it's not because we think TIPS have a much higher expected return than traditional bonds, but because of the inflation protection. We think they are less risky, and since we have a bunch of money sitting in cash today, diversifying some of that into TIPS make sense, even though we really don't love them at these yields.

But we have started to buy some. They're the first bonds outside of emerging debt that we have bought in quite a while, and it's a 10% position, so it's not huge, but it's the first increase in duration we've had in a while. And it's on the back of the backup in yields, which has brought the TIPS yields to be positive, if not as high as we'd like them to be.

Kathryn Spica: Touching on emerging-markets debt, it seems like according to your forecasts, it's the best of the worst among bonds. How are you looking at that segment, and what's been attractive about it?

Inker: Well, what is attractive about emerging debt is pretty simply the yield relative to the other things you can buy. The yield spread is a little bit narrow to our best guess at equilibrium levels, but one of the things about emerging debt is, unlike say high-yield, which is defined in terms of its credit quality, emerging debt's credit quality can change over time. And it has been getting better.

So, our view is its fair spread over Treasuries would be 3.5% maybe, and it's trading at 3.2%. So, that's pretty close to normal. The problem is it is normal on top of a Treasury bond, which looks worse than normal, but we feel like you've got to own some here. We don't think you want to be near the maximum position by any means, but it's a somewhat different risk than other risks you're taking in the portfolio, and you're getting compensated for taking it.

So, we think it makes sense to own emerging debt. The emerging debt we like most today is hard currency sovereign. The corporates don't make a lot of sense to us at today's spreads and the local debt is hurt somewhat by the fact that we don't think these currencies are all that cheap.

Kinnel: Timber has long been an area for which you had fairly high forecast returns. What's your outlook, and how can a planner put clients in timber if they want to?

Inker:  Today's expected return to timber is OK, but not better than that. One of the things you have to recognize when you are investing in timber is you're locking up your money for 10 to 15 years. And that takes away a lot of flexibility, and you should get paid for giving up that flexibility. So, the 5.9% return that we're saying today, is OK, but it's not better than OK. And even to get to the 5.9%, that's really driven by lower returns maybe about a 5% return on U.S. forestry assets and something like 6.5% from non-U.S. forestry assets.

So, if you want to get good returns, you got to go outside the U.S., and it is hard for most investors to invest in timber in the U.S. It's even harder outside. The problem of trying to invest in timber is that neither the forest and paper products companies nor the timber REITs is a really good steward of their forests, because they both have incentive to cut at the wrong times. If it's a forest and paper products company, they've got mills. They have to keep running because they're very expensive to shut down. So, even if the price of the logs is lousy, they'll keep cutting.

For the timber REITs, they have a somewhat related problem in that they're priced off of their dividend, and so they will keep cutting even if the price of logs is lousy. And one of the things we've always loved about timber relative to other agricultural commodities is if you're growing a corn crop, and the price of corn is not to your liking, you have no choice but to harvest your corn. So you will get a lousy return on it, because the price is much lower than you are counting on.

If the same thing happens with your forest, you don't have to cut down the trees. They'll keep growing. They'll get more valuable. So, if you owned forest land during the housing bust in the U.S., one of the things you can do is cut fewer trees with the expectation that as housing activity comes back up, the price of lumber will come back up and your returns will come up. So that really requires either owning the trees directly or investing in timber limited partnerships, both of which are difficult and time-consuming.

So, it's unfortunately a very difficult asset class to get at, much more comparable to private equity, than the other things on our forecast page.

Kinnel: You at least have positive return projections for Europe. Why?

Inker: Our outlook is better than the U.S. because the valuations are lower and expectations are worse. They have been going up, not quite as fast as the U.S., but still reasonably quickly this year, which has left their valuations looking less interesting. What we do see that looks pretty interesting outside of the U.S. is there is a pretty big gap between the growth companies and the safe companies relative to more cyclical deep value type names, which are looking interestingly cheap. They are risky.

If you look at the European markets, more cyclical companies are cheaper, more leveraged companies are cheaper and more European companies are cheaper. If a company does all of its business in Continental Europe and is cyclical, it's going to get hurt a lot worse, or it has gotten hurt a lot worse, than something that was more globally diversified and more stable.

So, the market isn't being capricious here, but the market is saying effectively it doesn't believe Europe is going to recover. You're getting paid for taking the risks, for willing to take a bet that Europe will recover. We are prepared to take that risk, but since it is hard for us to see exactly how Europe is going to recover quickly from here, we own an amount of European value such that we could own a good deal more if the price were to fall from here. So we're not all that close to our maximum allocation, but we own a pretty decent chunk because it's one of the cheaper things out there.

It is this strange inversion of what we see in the U.S. though. In the U.S., high-quality companies are trading at a discount and it's because they seem less special in a world where everybody's making lots of money. In Europe, the high-quality companies are trading at a pretty big premium because the ability to make money and the assumption that you will continue to make money seems to make them special. So, we are seeing a big discrepancy between the pricing in the U.S. and outside of the U.S., which means the kinds of companies in Europe we are interested in tend to look pretty different than the kinds of companies we're interested in within the U.S.

Kinnel: Do you differentiate within Europe from among the euro-denominated countries and the United Kingdom and others outside the euro?

Inker: Yes, although it's somewhat interesting. The U.K. actually looks decently cheap, as does the eurozone. Continental Europe ex-the eurozone, which I admit is this slightly strange combination of Switzerland, Sweden, Norway, and Denmark, doesn't look anywhere near as attractive as the eurozone, but the U.K. does look pretty close to as attractive as the eurozone. So we like the U.K., we like the eurozone; we don't much like the rest of the Europe.

Kinnel: What about Japan? There's certainly been a lot of interest in Japan, given its recent changes.

Inker: Yeah, we were big fans of Japan nine months ago and we thought it was the cheapest thing out there and we had a pretty significant overweight or pretty significant allocation. We've been selling in recent months and we no longer think it's particularly intriguingly priced. Nine months ago Japan was priced as if it was never going to get any better, and so you could buy it and say, well, if it never gets any better, it's priced to do okay, and if it actually gets its act together, it's priced to give you a really good return. Since then, since the pricing has changed, you are paying for the expectation that it will get its act together. While Abe and the new government have made some of the necessary moves to get there, it is by no means assured that they will get their act together. So I much prefer a free option to one that I'm paying for, and on our analysis you're paying for that option now, which makes it, not horrible, we still own some Japan, but it is certainly no longer one of our favorite markets.

Spica:  What are the challenges for implementing any of these forecasts or any of your views?

Inker: There is a little bit of difficulty. One of the reasons--I talked a bit about the fact that we don't act as if we believe the 7% for emerging equities. One of the reasons for that is the 7% is based on the valuation of the emerging companies. If you buy the companies, to some degree you get the currency along for the ride and the problem today is the currencies look a little bit expensive. So if you try to buy the emerging stock, you've got two choices. You can keep the currency and have some expected erosion of your gains from the fact that the currencies will weaken, or you could try to hedge the currency. But that's going to cost you. So emerging is in this slightly weird case where you can either keep the currency or get rid of the currency, in either case you're not thrilled with it. Otherwise, most of the other forecasts you can – we are expecting over the next seven years you will get these returns, with plenty of volatility around it, but they are our best estimate of the returns. The bad news is there's just not that much to be excited about.

Kinnel: You pointed out some of the issues with the risk parity strategy have kind of come home to roost lately. What's your take on what the recent markets have shown about risk parity strategy?

Inker: Well, there are a couple of things. The different risk parity implementations have different underlying assumptions behind them, but what a lot of them tend to assume is that the correlations between assets are going to be low. What the events of this spring showed is that's not always true, and what we think it's important for people to realize is what happened in May and June wasn't this weird, random event, meteorites striking the Earth in a way that's not happen again and could never be predicted. This is what you should expect to happen if cash rates normalize. It's not a guarantee that they will normalize, but it's a risk that's sitting there if you put together a portfolio and said, it's okay to lever this thing because the low correlations mean I'm going to be taking losses on one thing while I've got gains on another. That is absolutely not guaranteed to happen. You can rely on it less today given how low rates are than you could under normal circumstances.

The other problem we see with risk parity is that it's assuming that risk premia exist rather than checking to see if they exist before investing. So the assumption was that even at a yield of 1.6% on the 10-year, that 10-year bonds offered a risk premium over cash, it was far from clear to us that at those levels they did. Now, maybe at a 2.5% yield they do or certainly at a 5% yield they would, but the two things we think you really got to lookout for, and that we think in various ways a lot of the managers of risk parity ignored were, first and foremost, the correlations that they're assuming are going to be low are not always low, and we're in one of those situations where they could easily be higher in important and dangerous ways for an extended period of time.

The second one is just that just because an asset class has provided a return above cash historically does not mean it's priced to do that today. Levering up an overvalued asset class doesn't make it cheap. It is just a recipe for losing money.

Kinnel: Thanks Ben.