Hey, Investors, It’s Risk Versus Reward

Remember those complex financial products that helped touch off the financial crisis in 2008 — the ones with impenetrable names like “collateralized debt obligations”?

They’re back in vogue, according to my Bloomberg News colleagues. Anchorage Financial Group, a New York-based investment manager, used them recently to magically transform a collection of corporate junk bonds and loans into a AAA-rated investment. Yet S&P downgraded the U.S. government’s credit rating from AAA to AA+ in 2011, where it remains today.

That’s right –- there are investments stuffed with junk bonds that are more highly rated than U.S. government bonds. While this smacks of some of the financial crisis’s wackier moments, there’s a key difference: This time it’s investors, rather than big banks, that are taking high-octane risks.

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A Risky Assumption Lurks in Your Portfolio

Your portfolio may be riskier than you think, and it’s a good time to take note.

Hiding in most portfolios is a big assumption about risk — namely, that assets are uncorrelated (or at least less than highly correlated) to each other. So when one asset is down — emerging-market stocks, for example — a typical portfolio relies on some other asset to pick up the slack — U.S. high-yield bonds, let’s say.

Looking at the long-term data, the assumption that different assets chart different paths appears to be true. The following table shows the correlations since 1988 for a variety of assets commonly found in investors’ portfolios. The data show those assets are not highly correlated, implying they don’t move in sync — and, more importantly, they won’t fall apart simultaneously.

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Trying to Get Rich Can Be Highly Volatile

For 43 consecutive trading days this summer — nearly two months — U.S. stocks barely budged. The S&P 500’s one-day move never crept above 1 percent during that time, and the S&P 500’s average one-day move was just six basis points over that period.

That streak stopped when the S&P 500 tumbled 2.5 percent on Friday and then bounced back 1.5 percent on Monday.

It looks like investors expect the market’s newfound jitters to hang around for a while longer. The average value of the CBOE Volatility Index — a widely followed barometer of expected volatility in U.S. stocks better known as the VIX –- was 12.5 during those 43 tranquil days. The VIX shot up to an average of 16.4 over the last two trading days.

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The Re-Emergence of Emerging Markets

 Emerging markets are back.

While the U.S. has grabbed the headlines this year with every new record high for the S&P 500, emerging-market stocks have quietly done even better. The MSCI Emerging Markets Index is up 14.8 percent this year through August, including dividends, while the S&P 500 is up 7.8 percent over the same period.

That’s a sharp reversal from recent years. The S&P 500 returned 6.5 percent annually from 2008 to 2015, while the MSCI Emerging Markets Index returned a negative 2.8 percent
a year.  

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No Clear Path to Avoiding the Bear

Investors are in a defensive mood.

As my Gadfly colleague Mike Regan recently pointed out, the U.S. stock market has eked out modest gains since the S&P 500 notched a record high in May 2015, but defensive sectors have experienced gangbuster growth since then.

The S&P 500 returned 5.7 percent from June 2015 to July 2016, including dividends, while the S&P 500 Consumer Staples Index and the S&P 500 Utilities Index — two typical defensive sectors — returned 15.7 percent and 22.7 percent, respectively.

Defensive sectors have historically given investors a smoother ride than the broader market. Consumer staples and utilities, for example, had the lowest standard deviation of the 10 S&P 500 sectors from October 1989 to July 2016, the longest period for which data is available. At the same time, financials and technology — two classic boom-and-bust sectors — had the highest standard deviation. (Standard deviation reflects the performance volatility of an investment; a lower standard deviation indicates a less bumpy ride.)

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Retirement Plans Are Among the Fee-Stricken

Defined contribution plans — American workers’ golden road to retirement — are on the defensive. A mountain of class-action lawsuits is piling up against a who’s who of blue-chip companies and prestigious universities, accusing them of failing to look out for participants in their 401(k) and 403(b) plans.

The air is already thick with obligatory denials and earnest concerns for employees’ futures. But there’s no getting around the fact that employer-sponsored retirement plans are horribly broken.

If you have any doubt that retirement plans are ineffective, just take a look at the numbers. The Employee Benefit Research Institute and the Investment Company Institute jointly compile data on over 81,000 401(k) plans, representing nearly 25 million workers and $2 trillion in assets.

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Edward Jones Really Likes Those Fees

The Department of Labor rocked the brokerage world several months ago when it decreed that brokers must – horror of horrors – put their clients’ interests ahead of their own.

The so-called fiduciary rule (which applies only to retirement accounts for now) is meant to address a longstanding problem. Brokers routinely recommend mutual funds to retirement savers as an easy way to broadly diversify their accounts. But unbeknownst to investors, in many cases the mutual fund companies pay brokers to sell those funds.

Brokers would no doubt argue that this naked conflict of interest doesn’t influence which funds they choose to recommend. Maybe so, but the new fiduciary rule now forces  brokers to make sure that their clients’ interests are, in fact, top of mind. That means brokers will have to stop taking money from mutual fund companies altogether or disclose those payments to their clients — a conversation that will rightly raise some uncomfortable questions.

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Hedge Funds Bet on the Mating Dance

Poor, poor hedge funds.

Returns have plummeted and investors are fleeing. Pensions headed for the exits, and now endowments are close behind.

No hedge fund seems to be immune from the fallout. Brevan Howard and Tudor Investment are just the latest marquee funds suffering an exodus of investors.

But hope for some hedge funds and their hangers-on is springing up in a seemingly unusual place: abandoned mergers and acquisitions.

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Harvard’s Endowment Needs the Classics

The Harvard endowment — a $37.6 billion treasure chest that is Harvard University’s largest financial asset and is the world’s biggest academic endowment — is in need of a steady hand. The latest jolt came when Stephen Blyth recently stepped downas chief executive of the Harvard Management Company, which manages the mammoth endowment. HMC is now on to its sixth CEO since 2005.

If you looked at the Harvard endowment’s long-term investment returns, you might wonder what all the turmoil is about. According to HMC, the endowment returned a hefty 12.2 percent annually from July 1973 to June 2015. That handily beat a traditional 60/40 portfolio of U.S. stocks and bonds, which returned 9.7 percent annually over the same period. (Results for the Harvard endowment’s most recent fiscal year that ended in June 2016 are not yet available.)

In recent years, however, Harvard’s investment returns have dropped off considerably. The endowment lagged a 60/40 U.S. portfolio by 1.3 percent annually over the five years that ended in June 2015. And while the endowment beat a 60/40 portfolio by 0.8 percent annually over ten years, it achieved only a 7.6 percent annual return over that period, which is just barely enough to satisfy HMC’s long-term objective of a minimum real return of 5 percent annually.

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Legg Mason Enters Its Post-Bill Miller Era

It’s the end of an era at Legg Mason.

Bill Miller –- stock picker extraordinaire who famously outpaced the S&P 500 for 15 consecutive years, and undoubtedly a first-ballot-hall-of-famer –- is leaving the firm after 35 years.

Miller isn’t hanging up his stock charts for good. He will keep trying to outsmart the market at LMM, a money manager he owned jointly with Legg Mason that will now be all his own.

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