publication date: Aug 22, 2011
With stock prices falling and stock market volatility up,
CNBC has expanded their evening coverage of the carnage. They had their usual
assortment of experts, pseudo-experts and journalists on air recently to
address questions and concerns. And, they made the mistake of having Suze Orman
join them (
see my previous article on her background). Having observed her for
many years, I've lost track of how many clueless and erroneous things I've
heard her say.
But, just as some folks can't turn away from viewing the
results of an accident on the highway, I resisted my instinct to immediately
change the channel when she came on the screen. Within two minutes, she had
efficiently presented me with yet another golden opportunity to debunk some
silly investing advice she provided a viewer.
When to Invest in Bonds
In response to a viewer question regarding how to invest in
his company's 401(k) plan, she asked him if like most such company retirement plans,
were target-date funds offered. The viewer said yes which prompted Ms. Orman to
go on a rant against target-date funds. She doesn't like them because they
don't try to jump into and out of bonds based upon expected changes in interest
rates. (Bond prices fall when market interest rates rise).
An example of a target-date fund is Vanguard's Target
Retirement 2040 Fund, which is designed for investors expecting to retire
around the year 2040. The fund currently has about 90 percent invested in
stocks and 10 percent in bonds. In the year 2016 (about 25 years from the
expected retirement date), the fund will begin to gradually increase its bond holdings
while slowly reducing its stock holdings. That's what investors are generally
advised to do approaching retirement and a target date fund ensures that it
happens (at least for the money that an investor has in such a fund).
Suze Orman: Wrong Again!
In the world according to Suze Orman, investing in bonds is
a simple matter of figuring out which way interest rates are going to go and
then making your bond investments accordingly! Of course, this is absurd and
near impossible to do, even for the vast, vast majority of professional money
managers.
If you can consistently predict which way various interest
rates are headed, you could make a fortune correctly betting on various
financial products the performance of which depend upon which way interest rates
are going.
Listen to Vanguard, Not Suze Orman
Vanguard recently published a useful report on this topic
entitled, "Rising Rates: A Case for Active Bond Investing?" Here are the key
insights from that report:
"Although the success of active management in fixed income
has not been stellar-Vanguard research has found, for example, that over the 15
years ended December 31, 2010, more than 85% of actively managed bond funds
failed to beat their benchmarks-still there are distinct periods in which
investors may prefer active management. For instance, during a rising interest
rate environment, it is often supposed that active fixed income managers will
outperform their benchmark, given that active managers can shorten a
portfolio's duration, thus mitigating the risk of rising interest rates.
This paper tests this assumption by reviewing the historical
track record of active bond managers in Morningstar's mutual fund database
during periods of rising interest rates since 1981.
...We found that in a majority of rising-rate periods, active
managers, on average, failed to outperform a relevant benchmark. The
implication of this finding is that investors should not assume that an active
manager will automatically transform an opportunity to outperform into actual outperformance.
...Given active managers' ability to position their portfolios
according to market conditions, why has outperformance during rising-rate
periods been so fleeting? There are two likely reasons: first, the effect on
the market of the zero-sum game; and, second, the difficulty of predicting (and
therefore capitalizing on) interest rate movements.
The concept of a zero-sum game in investing starts with the
understanding that at any given point in time, the holdings of all investors in
a particular market, such as the U.S. bond market, aggregate to form
that market. Because all investors' holdings are represented, if one investor's
dollars outperform the aggregate market over a particular time period, another
investor's dollars must underperform, such that the dollar-weighted performance of all investors sums to equal the performance
of the market.
In reality, investors are exposed to costs such as commissions,
management fees, bid-ask spreads, administrative costs, market impact, and,
where applicable, taxes-all of which combine to reduce realized returns over
time. As a result, after costs are considered, investors' dollar-weighted underperformance
exceeds investors' dollarweighted outperformance. By extension, a majority of
investor dollars also therefore underperforms the market index...the average dollar
invested in actively managed bond funds was charged 54 basis points (0.54%) for
government funds and 56 basis points (0.56%) for corporate funds, amounts that constitute
significant hurdles for those funds to overcome to outperform a benchmark.
As stated, we also want to emphasize how hard it is to
correctly predict interest rate movements (and, for corporate bonds, credit
spreads and sector performance) consistently over time...As observed in previous Vanguard
research by Davis et al. (2010), the forward yield curve of the Treasury market
reflects the aggregate perspective of investment managers on future interest
rates. Note that forward rates do not represent any individual's or
organization's views about future interest rates. Instead, the forward curve
represents the aggregate expectations of all Treasury bond-market participants
regarding future interest rates...
Of course, history suggests that interest rates will likely
evolve differently from today's expectations. Indeed, as Davis et al. (2010)
also showed, the Treasury forward yield curve has been a poor predictor of
actual future rates...A timely example of this evolution of actual versus
expected rates has transpired since interest rates bottomed in 2008. Since that
point, market participants have been forecasting higher future interest rates.
Yet, despite the clamor for higher rates, yields have remained low, with little upward pressure.
Finally, in addition to interest rates' unpredictability, it's
important to consider that even if a manager makes a correct call on the
direction of rates, the timing and magnitude of any change are crucial...In an
environment characterized by a steep yield curve, this negative carry can mean
a significant return forfeiture if yields do not rise as anticipated.
Even then, a manager who correctly predicts a rise in
interest rates could likely suffer a performance penalty if rates rise less
than forecast or if the timing of the change is either too early or too late."
For more specific investing suggestions and ideas on this
topic, please see my previous article, "
Dealing With Worries About Rising
Interest Rates".