Diversification in a Low Yield World

Fixed income investments and savings vehicles do not look at attractive at the moment. With interest rates fixed at nearly zero, bank CD and savings accounts are paying very little.

When the Choice is Easy

One living trust I manage has an interest rate of only .30% in an FDIC insured savings account. It is tempting to chase higher yields, but in this case the investment horizon is measured in weeks, not months, and my fiduciary responsibilities will switch to the trust’s beneficiaries soon. In this case, preservation of capital is more important than investment yield. And because money market accounts and other liquid fixed income investments aren’t paying much more, the FDIC insurance becomes a more valuable consideration. Because the trust has 18 beneficiaries, the normal FDIC coverage limits don’t apply, and the over-$500,000 in this account is fully insured.

But if your investment time horizon is more than just a few weeks (or, at least you think it is), that .30% interest rate isn’t very attractive. Investors seeking to keep their portfolios diversified are more tempted to chase yield.  But there are pitfalls in doing so: increasing default risk, interest rate risk, and inflation risk. It is possible to create a portfolio of fixed income investments that are riskier than a portfolio of stocks if you aren’t careful, and many investors don’t realize that.

MPT and the Fixed Income Portfolio

MPT, or Modern Portfolio Theory, is the idea that you measure risk of the entire portfolio, rather than each individual component. This allows you to include some higher yield investments even though measured individually, they would be considered risky.

I’m in my mid-fifties, and have 30% of my portfolio in fixed income investments. A year ago, I divided up the fixed income portion of my portfolio into equal thirds, and purchased three relatively  “safe” bond ETFs, iShares LQD Investment Grade Corporate Bond, iShares SHY 1 – 3 Year Treasury Bond and iShares TLT 20+ Year Treasury Bond funds. These funds carry a low .15% expense ratio, and trade at no cost in my brokerage account at Fidelity.

Really, none of these are “high risk” bond funds. No “high yield” among them, but you can lose money in a bond fund, and this is the portion of my portfolio where I am the most conservative.

The short term Treasury fund, SHY, returned 1.6% over the past year. That’s certainly better than the yield on CDs or savings accounts, but just barely. The corporate bond fund, LQD, returned 12.82% over the past year, a much better return, inducing smiles and bragging rights (and every investor knows, you only talk about your “winners”). At the time, I considered the long term Treasuries to be the riskiest of the three, as many feared the Fed’s qualitative easing would induce inflation, destroying the returns. The TLT 20+ year Treasury fund returned 34.67%, so the risk was worthwhile.

I declared myself a genius and rebalanced my fixed income portion of my portfolio to overweight corporate and short term Treasuries (at 40% and 50% respectively). The corporate fund has a YTD return of 2.27%, and the short term Treasuries are at .02%.  The long term Treasuries are now at 10% of my fixed income portfolio, but the YTD return is a negative number, -3.86.

Buy Low, Sell High

The temptation is always to “go with the winner” and pour more money into what just went up. But I felt I was on borrowed time with the long term Treasuries, and the pundits were finally right … I sold at the right time. But should I have shifted more money into the corporate bond fund instead of over-weighting the short term Treasury fund? Yeah, the YTD returns mock me in that regard. So I’m not so smart after all. And we won’t look at my individual stock picks over the past year, either.

I may consider higher yield bond funds in the future, especially as the outlook for earnings on the Treasuries to be low. But the risk/reward ratio also swings the other way, and the fixed income portion of your portfolio should be the least volatile, and the safest.

Low Yields Tempt Investors

The extremely low yields on fixed income investments such as bonds, money market funds and savings vehicles at banks may be tempting investors to “chase yield” and incur more risk.

When Standards Are Low

The Treasury bond has long been the benchmark for stability, but yields may go below zero:

The Treasury Department said it plans to decide by May whether to start selling securities that would let investors pay for the privilege of lending money to the U.S. government.

The current auction system doesn’t allow debt with a negative yield to be sold in the primary market. In the secondary market, where investors trade Treasury securities among themselves, yields on short-term debt often have been negative in recent months.

The Federal Reserve has signaled its intention to keep rates low for the next few years. Investment Advisors are worried that persistent low rates will induce investors to take more risk in investments that promise higher yield and seem safe. The Financial Industry Regulatory Authority Inc. (FINRA), the primary regulator for broker/dealers and investment advisors, released a 16 page letter indicating they are concerned:

“Finra is informing its examination priorities against the economic environment that investors have faced since 2008, as these circumstances have steadily contributed to conditions that foster an increased risk of aggressive yield chasing, inappropriate sales practices, unsuitable product offerings, and misappropriation and fraud,” the letter states.

“Given the low yields on Treasuries, we are concerned that investors may be inadvertently taking risks that they do not understand or that are inadequately disclosed as they chase yields,” the letter continues. Lack of liquidity and inadequate cash flow in investments also are red flags Finra is monitoring.

Beware the Jabberwocky

While Treasuries and investment grade bond funds remain relatively safe for preservation of capital, there are hidden dangers in funds that focus on higher yields. Those of us who remember the “junk bond” defaults in the 1990s know that “fixed rate”, “bond” and “guaranteed return” are not synonymous with “safe”.

Investors seeking higher yields to “beat the market” may be able to move more of their portfolio to stocks, mutual funds, ETFs or other investment vehicles. Seeking out a  fee-based investment advisor who does not generate commissions on sales of stocks and bonds would be the first step in this process. An investment advisor should assess your financial goals, risk tolerance, and the current market conditions to tailor an investment plan.

401k Plans Have Hidden Fees

While unknown to most participants, 401k plans often have fees that are not found in the prospectuses of the underlying mutual funds. Administrative and management fees are deducted from the account of every investor.

The U.S. Department of Labor (DOL) regulates disclosure rules for 401k funds, and is set to implement new reporting rules, probably by May, 2012. All 401k plans will have to disclose all fees on a quarterly basis. The new disclosures are intended to give more power to investors:

The new rules will require an explanation of any administrative expenses and individual expenses charged to the accounts. The information can now be ferreted out by participants and plan sponsors, but the new regulations will require it to be offered regularly by the plan providers.

This is a good first step toward more transparency for investors.

Note: There are often “hidden” fees in mutual funds themselves; in additional to the fees in the prospectus, a mutual fund may “disclose” fees in the rarely read Statement of Additional Information, a report that is available only if you request it.

Update Feb. 4, 2012: It looks like the new rules will start on July 1, 2012.

Who Are the 1%?

We tend to think in static terms when discussing economic status. The poor are always poor, and the rich . . . those one-percenters . . . always stay on top.

Dynamic Positioning

But American capitalism is extraordinarily dynamic, with constant movement between income classes. It’s not just the middle class that sees their income fall and rise as situations change. Even the millionaires see their incomes and net worth fluctuate wildly.

The dynamic positioning isn’t due to bad decisions by the millionaires; it isn’t due to buying too many cars, or using $100 bills to light cigars. It is the same movement between income classes seen when looking at the poor, the middle class, and the rich-bastards-who-earn-more-than-me.

With a hat tip to Veronica De Rugy at George Mason University’s Mercatus Center, millionaires are unlikely to remain millionaires for long:

The data reveal that, after one year, roughly half of those who were millionaires  at some point between 1999 and 2007 remain. After the second year, 15% or roughly 102,000 millionaires remain.  This decreasing rate of remaining millionaires persists, and only about 6% or 38,000 millionaires remain after the ninth year.

One of the primary catalysts for the Occupy Wall Street movements is the idea that disparity between top earners and everybody else is widening. However,  economic mobility and transiency of the millionaire income group is high. Many top earners are likely to lose their membership in the millionaire’s club.

Do the Poor Always Remain Poor?

The plight of the truly poor is a bit different. The sure route from poverty to the middle class is to do three things: finish school, not get pregnant outside of marriage, and get a job . . . any job . . . and stick with it. Even without doing all three, movement is possible with just two of them.

You don’t need a formal education to start a small business as a sole proprietorship (thereby avoiding expensive licensing in most areas of the country). Service businesses, such as lawn care, swimming pool maintenance, etc. can be profitable for those that  work hard. When you make it, you’ll want to protect your growing assets by changing your business structure to a LLC or other format. But in the beginning, a sole proprietorship is fine.

Raising a child as a single parent is incredibly challenging, and one of the most difficult economic challenge to overcome. There are limited options that make sense. You can combine your child care needs with your job (such as working in a day care center or . . . subject to local laws and regulations . . . opening your home to take care of other children). It may take years to see the light at the end of the tunnel, but only if you don’t repeat the error and have more children out of wedlock.

The one thing that is essential is to get a job or start a business and stick with it. Hard work and persistence usually pays off. Who knows, you might someday be a millionaire . . . for a year or two.

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This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person. This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. There is no guarantee that investment in any program or strategy discussed hereinwill be profitable or will not incur loss. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended and should understand that statements regarding future prospects may not be realized. Investors should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Individual client accounts may vary.

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